Allegion plc (ALLE) Earnings Call Transcript & Summary

Thank you. This is Chris Snyder, industrials analyst here at UBS. First off, I want to say thank you to everyone on the line for joining. We're very excited to have Dave Petratis with us today, CEO of Allegion; along with Kevin Sawyer, Director of Investor Relations. As most of you know, Allegion is a leading supplier of security solutions here in the Americas. It is a very interesting time for Allegion. And while many industrial end markets are seeing tech and software come to the market, the security and access control industry is really at the center of this intersection. In addition, we also have a nonres construction cycle that is beginning to turn. so with that, I want to welcome Dave Petratis, CEO of Allegion, a position he has held since the company spun off from Ingersoll Rand in 2013. Hi, Dave. How are you?

Good, Chris. Thanks for having me today.

Oh, absolutely. Very excited.

Wanted to start off with the market before we maybe get into company strategy. And one thing that kind of always stood out about Allegion is the strong relationship with spec writers and architects. Can you talk about, one, I guess, the advantage that this provides the company? And then also what are you seeing in the pipeline right now as much of the leading-edge nonres indicators have been running quite strong?

So first off, particularly in the North American market, Allegion is blessed with one of the strongest base of spec writers in the industry. Some 20 years ago, Ingersoll Rand reeled those in so that there are company-owned employees operated. It's differentiated in the marketplace over the last 20 years and it's clearly a strength of the company. If you think about the bill of materials in new construction, hardware and access might represent some 5% of that bill of materials. And architects put a trusted relationship in our spec writers to get the complexity right to meet the various building codes. And we're often one of the last things that go on a job the last 45 days. And that any kind of inspection by fire, insurance, energy efficiency codes, they'll be building pressure tests that will exceed the need of that capability, so I would describe our position is leading in the marketplace. It's a complex place and we have a trusted relationship, so it really differentiates us when you get into the institutional arena. In terms of market indicators, Chris, you've got to put a smile on your face after 400 days of a pandemic. We went into this market strong and had a record Q1 2020. And then things kind of fell apart because of the pandemic, first, internationally, but as we see of building indicators, which would be the Dodge Momentum index, ABI, residential starts, all along the residential, there is a lot of momentum in that. There's also, I think, businesses opening up. There's confidence at both the consumer and, I would say, decision-maker level. Remember again we were locked out on a lot of repair and replacement-type markets; and that access has put certainly momentum, yes, in the order and book rate of Allegion.

Appreciate that. Most of the investors on the line, I mean, I think, track the Dodge start data [ really, which has ] inflected positive here this spring. With security, as you mentioned, the late-stage installation, can you just remind us of the lag or even the range of lag, depending on product size, from when that start data begins to drive security demand and specifically from the nonres new construction business?

I'd say there is clearly a lag. We're toward the end of the construction process, but think 9 months on a simple commercial strip mall project. Think 18 to 24 months as you roll into the more complex jobs. Now with that said, there was also a delay of projects because -- let's say you're on a college campus, Columbia University, the University of Iowa, the University of California, Berkeley. There was a stop in those projects because they didn't want outside players coming in. Those have restarted. So we see that today. There is clearly a lag with shovels in the ground [ and are part ] of that, but I like the momentum on all fronts.

I guess, following up on that, on the projects that were essentially stopped during the pandemic, when did those start to come back? I'm assuming there are some regional differences, but is that a -- like a 2021 event? Or is that you're seeing that as early as last summer?

No. I would say in -- and particularly hospitals and college campuses, we saw none of that last summer. And if you're a facility manager at the University of Pennsylvania, you were worried about providing social distancing, the movement of people. That was the priority aim. A year later, as we move into the summer, those projects are kicking in. And it will be -- we saw that momentum beginning in March. It's continued as confidence. The pandemic is subsiding. And we like what we see in terms of restocking of distributor shelves, wholesale shelves; and the reengagement of those projects that were delayed last year.

Okay. No, appreciate that. So essentially you have that coming back this year, offsetting maybe what would be the -- or what will be the trough in the nonres new construction business and maybe just won't trough quite as deep. I guess, relative to maybe 6 months ago, it seems like the nonres recovery has come quicker than maybe not only Allegion expectations but, I think, market expectations. I guess, one, has it? And two, has anything surprised you just around how quick some of this activity appears to be coming back?

I'd say there is momentum in the recovery. It's coming back quicker than I would have anticipated. A lot of it is small [ parts ] project in nature. Let's say less than 1 million projects that were delayed. You still have to kind of get your head around, during 2020, there was a lag in commercial and institutional starts. And I'm still monitoring how that recovery is conducting [ itself ]. And we'll have more information on it as we move into our Q2 reporting, but it's faster and more positive. And you can see it happening in some of the more early-cycle activities, whether it's the electrical space, HVAC on a variety of levels. Those things are moving. And I like that pattern and I like those indications. It will be good for Allegion.

No, yes, absolutely. Any specific nonres verticals that are maybe running particularly hot at the moment?

I don't -- I wouldn't say hot. I'd say, number one, the confidence of wholesale and contract distributors, contract hardware dealers -- when they started seeing positive signs, higher vaccination rates, infection rates declining, access into buildings, we saw that momentum in our order rate. And it continues to happen, the reengagement of those new projects, particularly on college campuses. Then you have we're still sorting out the hangover in the hospital, but again, we were locked out of hospitals. Our partners were locked out of hospitals unless it was critical. Those small-project preventive maintenance work will kick in as the critical nature of the health was that -- those infections leave, the hospital returns to normal.

I guess, kind of following up on your comments around channel inventories or in with the wholesalers and distributors, are they fully restocked at this point? I just know globally [ and across ] every vertical there's shortages. Have they been able to restock to the point that they would like? Or do you think that, that could be -- that restocking could carry through the end of the year?

I think our strongest distributors continue to bet long, so they were in good shape, but there's a clear rebound going on. We'll be able to give a better sense of that in -- at the end of Q2. Then a couple things that you can see in our performance through the pandemic: Our supply chain and our ability to continue to manufacture through the pandemic was exemplary. It's rewarding us. So I think we get better activity when our wholesalers choose to reload; said another way, gaining in share across both the res and nonresidential space. Yes, I think, Chris, I'm extremely proud of, when you talk about the strength of those spec writers and our feet on the street, I didn't touch any of that on a worldwide basis. I took costs out, but it was not in those front-facing customer support aspects, and we're going to benefit as we go through this recovery.

Appreciate that. And you mentioned the distributors or -- and the wholesalers willing to bet long. I guess, from your standpoint -- and I'm assuming you're seeing a lot of the same things they are, but I guess, what is the supply chain seeing that gives confidence that this is not just a release of pent-up demand coming out of the winter when a lot of projects were seemingly pushed to the right; or just a return of activity of all what you talked about before, projects that were essentially shut down and are now starting back up, but rather there's true underlying sustainable demand? This is not -- we're not going to be talking about starts rolling over at the end of the summer or in the fall. I guess, what are you seeing? What's the supply chain seeing that's giving that confidence?

I think, number one, you've got to think through different economic ruptures of the -- of maybe my lifetime. Think about the financial disruption 9/11. And go back to the dot-com bubbles. Those things all have their unique patterns of disruption in demand; the pandemic, in my mind, quite unique in that you had almost a hard stop globally 45 days minimum. In some areas of the world, that was even longer. And it messed up primary supply chains but then include freight, include the availability of labor, while demand, particularly on res-related items, was accelerating. So you can have markets and demand structure in free fall, but generally there's going to be a decline in certain elements, whether it was freight or especially res-related stuff. You had this adrenaline shot. And it's going to take a while for supply chains to normalize themselves. I think companies like Allegion that had extremely strong supply chain kept our front-facing people strong. I think we're going to gain. We are gaining and will gain share on this.

Yes. It's interesting. And I guess kind of you referenced the global financial crisis. And if my memory serves me correctly, nonres didn't make a -- didn't surpass the 2008 high until, I believe, 2016. I think expectations are for that this recovery to surpass the 2019 high well above an 8-year time horizon. And I guess, could you maybe, from your experience, compare what you're seeing now to what you saw 10-plus years ago in terms of, I guess, the speed of the recovery, end-market health? Do you think that there can be any potential end-market impairment this time around? I know like it's 15 months later and we're still working from home. Any thoughts on that?

So I think, when you go back to the financial crisis, there was an absence of residential demand. I think we just hit 1.7 million in single-family starts. That would be normal for the previous 3 or 4 decades, so you have big void there. And res tends to pull through commercial and institutional activity. And as we enter this one, you've got a huge adrenaline shot in res activity that I think is going to carry on for certainly 5 -- there's almost 3.2 million units in deficit. So that's a good driver for commercial and institutional that was absent a decade ago. And I think we're going to see commercial and institutional levels of demand snap back pretty directly with some forces that were -- the office that we went into the pandemic is going to be different. There is going to be commercial and retail real estate that's repurposed. I like our opportunity there, especially with our position around seamless access. Electronics, touchless are accelerating.

Yes. No -- and I guess I'll take that commentary to talk about the aftermarket side of the nonres, which turns faster in both directions. Allegion's nonres business [ right around the line ] includes both renovation or upgrades but also just ongoing break-fix type work. So I guess, can you talk about activity in that aftermarket? How is that coming back? And then on top of that, is it reasonable just to think that the pandemic has accelerated the secular trend towards seamless access and touchless entry? I think most people would agree the market was going there. Is it fair to think that a lot of those investments will be pulled forward to accommodate the reopening?

I'd say, when you've got pent-up backlog of preventive maintenance activities, particularly in the institutional arena which -- when you have the installed base that we have, it's going to be good for Allegion. Second, as people return to the office, that platform is going to be changed. I think we'll see commercial office inventories actually increase, the availability. Those spaces will be repurposed, and I like that opportunity. As you move to electronics: Allegion was growing at low double digits pre pandemic. And I expect that is returning and will continue to -- it will return to that conversion point and I think there'll be accelerators. When people's work patterns change -- I may come to the office. It may be on different days and maybe different hours. As those work patterns change, I think it will accelerate the conversion towards digital access, keyless access, touchless access that Allegion is well positioned to participate in.

When you talk about -- and I don't know the exact phrase you used. I think it was something along the lines of like pent-up demand on in -- on the aftermarket. Is that great fix work that has just not been done over the last year? Is that these upgrade or renovation projects that have been soft? Or is that customers that, say, upgrade every 5 years or X number of years and they didn't do it last year, so now there's a catch-up? Maybe all. Any more color on that?

So number one, think about every hospital potentially in the world but certainly in North America. Your preventive maintenance list went off the -- in small projects went right off the board unless it was a crisis. The focus of those facilities teams went to a different area. That focus is returning. College campuses are another great example. You go back to last -- June 8 of a year ago. It's like how do I get 75% less people in a classroom or a building so that I can social distance and continue to operate. It was a completely different game. Or it could be just deliver this [indiscernible]. So there -- in my mind, there's a year of pent-up demand on both of those key institutional spaces that were just neglected -- and it's not neglected. It was a high priority.

Yes, yes. No, understood, understood. I guess, on those 2, hospital and university, I think they were ones that, this time last year, we were all worried about or the market had concerns about the financial health of those. I mean I think the hospitals had pressure on the back of COVID. I think people were concerned about universities, enrollment, tuitions in a remote world. Can you just talk about the health of those 2 key customer bases? Because I think it's fair that, that has some impact on their willingness to invest.

I'm extremely pleased with the health of state and municipal budgets as we've rolled through this. Not all of them are in good shape but, I think, relatively came through in good shape. You've also got increasing real estate values, which is a good bellwether for state receipts. And the security remains on the mind. There's new problems. "Was my hospital able to withstand the enormous pressure that they were under?" People rethink access and flows. And college campuses, I think new problems to be solved that access and flow of people will be on the top of mind. So I like our -- I like the change and I like the opportunity. And I think the overall health budgets are good. And unfortunately, the security threats don't go away. You look at some of the social unrest we faced a year ago. There's people that are thinking, "How do I get a higher level of readiness so that, if the threats come [ in, in any way ], I'm better prepared?" Lockdowns [indiscernible]...

No, makes sense. Appreciate -- yes. No, appreciate that. Now maybe turning to residential a little bit. There are certainly secular tailwinds here both from a macro perspective. I think you kind of hit on a lot of pent-up demand in housing and just the sluggish growth we've seen in household formations for a decade-plus now and then obviously the other secular trend of this electronics in the security market, but with that said, Allegion is going to run into some pretty tough comps on the resi side in the back half of '21 and then probably at least through, I think, the first half of '22? How should we think about the residential market over the next 6 to 18 months?

I think demand patterns will normalize. And I think we should think of good, solid mid- to high single-digit growth, with the accelerator being electronics. We -- if you go to Consumer Reports, 3 of the top 10 locks are ours. 3 of the top 10 locks are Allegion's. We have the highest-rated WiFi-enabled lock on Amazon, with thousands of reviews. Those electronics, that's particularly in the new build side of it which is very strong, are pulling through the remaining hardware. In a single-family American home, think about 21 doors. Including the electronics that can go in the front door, the mudroom door, to the garage, maybe the back door, that very substantial electronic position pulls through the rest of it. The Schlage Encode, approaching 600,000 installations, its connectivity, battery performance are things that differentiate that product. And it pulls through the other suite of products.

Appreciate that. So I mean, if I understood the comments correctly, it sounds like you would expect residential to be a mid-single-digit, high single-digit kind of through-cycle grower. And I guess it's fair to think that you -- just given that electronic secular tailwind, you guys would outperform just broader residential construction through cycle.

I think the electronics is a differentiator. We get the -- one accelerator is just the advance of new construction. At 1.7 million starts, you've got to like that versus where we've been in the last decade. I believe we're going to have to build at that pace certainly for the next 5 years to cover the deficit. And then I get the replacement side of it as well. You've got people that are investing in their homes, the existing structure. And again, electronics and the reliability and style features of the Schlage brand, I think, positions us well.

Yes. And I guess kind of following up on your comments before that nonres essentially lags res. You build out residential houses. You need nonres to support those developments. Going back kind of to other strong resi cycles, do you have any sense of what kind of that lag is? Is this immediate? Once the houses go up, we see nonres. Or is there usually a bit of a delay there?

It will be different this time because of the change in e-commerce behaviors. Go to areas that are hot, Texas, Arizona. You see big infrastructure build-out, particularly in retail. When you establish a new Pulte community or a new Horton committee, I don't know what the view is, but it's going to be interesting. Those are not going to be as accelerated, but the hospital, the K-12 school, the firehouse, those are things that won't change. It's just understanding how retail is affected long term because of the -- just acceleration of e-commerce in every way.

Appreciate that. I mean you talked a little bit about the installed base before, which is a competitive advantage for the company that, I think, whether it's defensibility versus incumbents and new entrants and also an ability to drive aftermarket revenue. Have you guys ever been able to quantify how big the installed base is?

It's large: the Schlage brand, 100 years; Von Duprin, which is the exit device, 100 years; LCN, 80 years. And typically, especially in the commercial and institutional, when you retrofit and replace this like-for-like of -- a Von Duprin exit device has a signature about it, an architectural signature. We work hard to make sure they honor the original spec. So it keeps giving. I think, two, when you move into the residential space -- I talked about the performance of our e-locks, but our residential products come with a lifetime guarantee. And if you just replaced a competitor or an import that's fallen off the door, the Schlage brand is in a very nice position.

And so it sounds like it's extremely difficult, if possible at all, to unseat an incumbent who has the installed base, whether it's for break-fix work, like a lock breaks; or even renovation if you are renovating one floor in a building. Like that -- is it fair to say that rarely, if ever, happens?

It's part of the moat. The more complexity in the building, the deeper the moat gets. And it's everything from, let's say, master key systems or electronic connectivity. Or when you go out an exit door into the jetway at O'Hare or LaGuardia, it's going to be a Von Duprin exit device. Those -- that's a build-to-order product specifically engineered for that product, so the moat is formidable. And -- but I often think, when I think about Allegion, we manage complexity. We do it very [ well ]. We do it very profitably, but it solves access problems both mechanically and electronically. And it gives us, I think, the growth, the positioning and the profitability that investors should understand.

I think -- I appreciate that. I think kind of the commentary around the moat kind of leads us into the tech conversation. So I have written that the rise of software and technology in the space will expand the touch points and addressable market for the legacy providers such as Allegion, with the opportunity to add more services and [ tools which ] you're providing today, but it's also bringing a new set of disruptive competitors that are generally incentivized to grow and [indiscernible]. So I guess, just straightforward, can you talk about the tech software opportunity? And do you view it as an opportunity or a threat?

I'm all in on opportunity, man. Chris, put on your seat belt, baby. I am all in on the opportunity. And I would classify the evolution of our industry from mechanical to electronics similar to evolutions that have gone on in factory automation, similar to evolutions that have gone on in lighting, critical power, even smart water management systems. These mechanical capabilities have gotten much more intelligent. You would -- I believe we come at it from a position of strength with this complexity [ in ] brands and architectural specification. We have invested significantly in software stacks that will -- that are and will continue to give us the adaptability for customers so that we can be the provider of choice as this industry continues to evolve towards seamless access. The mechanical forces that have built this company over the last 100 years are not being thrown out the door. They become more connected, more intelligent through software specs that open up new ecosystems for growth.

Appreciate that. And I certainly believe there is a very big opportunity here I kind of -- as I previously communicated. My concern would be that, if we see software kind of increasingly become the value driver in this market, does that risk -- does that pose a risk to hardware margins? And I -- because one thing that I looked at -- we did work on automation a while back. And I remember robot pricing has like been down for -- I mean I don't know the exact number but almost 20 straight years. And in that market you're seeing the value shift away from hardware, into the software, so I'd be interested to your thoughts on that because, again, like a lot of these software companies are incentivized to grow. When you're incentivized to grow, it's like, okay, how do we take costs out of the ecosystem, so to speak?

So I'll give you a couple of comparisons. One, go back and look at -- it was then called the Allen-Bradley Company out of Milwaukee. They were an electromechanical company. They transformed into Rockwell Automation. What happened is electrical mechanical components became much more connected, and you took a $2 billion company to a $7 billion or $8 billion company. I believe the access security business is along the same front. And I think you've got at -- this moat we have. The software guys are not going to be able to produce 2,200 variations of the Von Duprin exit device [ or, I mean ], 38 million variations of the Schlage master key systems. I think it goes the other way. Software and unique software companies will play a role, but I do not believe it degrades the value proposition that we're providing. And that's the key access and security at the forefoot that takes physical forces. They just become more connected, I think, more user friendly because of your edge device. And I think the evolution coexists, and I believe it opens up opportunities for Allegion.

Appreciate that. And then you guys have talked about your tech strategy broadly kind of in terms of build, borrow, buy. Can you maybe elaborate a bit more on that? And then maybe specifically, what are included in these build, borrow, buy buckets?

So build, borrow, buy [ have ] some of the best technical software stacks so that we can own, partner with any player out there. It could be things like visitor management. It could be time and attendance. It could be companies like Openpath, but the build have software stacks that integrate into our mechanical connectivity and complexity, have the ability to apply APIs and SDKs so that developers look to us as the partner of choice. This is a critical aspect of our strategy. And then use our venture activity to observe, learn, partner and potentially own, like we've done with Yonomi, to accelerate our position. So it is a build, borrow, buy; taking the software capability on both the commercial and institutional as one stack of software capability and the res stack to move the company forward towards what we call seamless access.

Appreciate that. So I guess -- so just to make sure I'm understanding it: So the -- Allegion does want to be the partner of choice for these software companies, these tech companies enter the -- entering the space, but at the same time, through the -- obviously you guys with the Yonomi acquisition, the venture investments, we shouldn't be surprised to see Allegion try and developing their own software as well.

We are building our own software today and it's around these stacks and experiences. The Allegion ENGAGE capability allows us to partner with a group like CBORD or Castle systems to be able to navigate through Ohio State University or the University of San Francisco with an edge device. And it allows you to not only move through buildings, purchase books, purchase food through your edge device. That happens today.

Appreciate that. And then so I guess, kind of on the Americas, operating margin has been running at 29%. This year, there are some mix headwinds, whether it's residential. Or I think you guys, on the last call, called out mid-tier-type projects, but as we kind of look past 2021, '22 and 23, like is it reasonable to think that, that Americas margin can go higher than where it's been?

I think our value proposition historically has been industry-leading organic growth and the ability to be able to leverage that, and I would look to that pattern to continue.

Appreciate that. [indiscernible] that same margin topic; if you can talk a little bit about how price, cost conversations are going. Allegion has a really strong pricing track record. I think pricing is up every year since the company spin-off, but can you just maybe talk about how those conversations are going? You would think customers kind of understand where the price increases are coming from.

I'd say we announced price increases in the first quarter, effective April 1. It's [ a area of my ] business career. The price lever is an important lever for success. And we've been very aggressive on the different factors, metals, freight, wages. You've got a lot of pressures on that, and we've been particularly active in pulling that price lever. Kevin, anything to add to that?

No. I mean just historically, like you said, you're looking at the price. Obviously it comes on the nonresidential side of the business, right? Tougher to get that price in the residential markets, for sure.

Appreciate that. The -- then I guess, kind of on the international side, that business has had a pretty sharp turnaround in the past couple quarters. Can you maybe talk about the drivers of the improvement there, I guess, primarily on the margin side? And then how should we think about that going forward? Is this improvement a base that we can build off? And then I guess, really long term, like at what point would the international market start to run up against a margin ceiling, so to speak, just because it is so geographically diversed?

So extremely proud of our performance in '20 and then the Q1 '21 in the international arena. I think a couple of things to think about there. We've been investing in the electronics side of it, human and capital deployment into our Interflex and SimonsVoss business. And they have performed extremely well and are taking share in those regions, one. Number two, remember, 24, 36 months ago, we purchased GWA in Australia at the peak of the residential market. Our timing wasn't perfect, but we believe that's a very good asset as residential markets in Australia recover. We think the whole driver of seamless access and residential recoveries will be good for us. The product is called the Trilock. It's the first electronic version available on the market. And I think our overall focus on that New Zealand and Australia place -- space, with the addition of Gainsborough -- we're coming out of this much stronger than we went into it. Another one that's been good for the international markets that's helped us grow that I think people are unaware of is our portable security business. Kryptonite, AXA and Trelock, because of the demand for bikes, has performed very good for us and is one of the elements that go into the international reporting that has been a good shot in the arm for the business.

Appreciate that. If I can just squeeze one last one in, if I could, when you look at your product portfolio: And I think the products have varying degrees of tech exposure or tech -- being tech enabled or connectivity enabled. As you go up that kind of technology stack, so to speak, and become more integrated with tech companies, is there margin pressure on those offerings? Or is it relatively similar?

I'd say no. We move into new ecosystems because of the strength of our software stack that open up, I think, new, very profitable revenue streams, recurring revenue streams; [ access by the drink ]; capabilities that make college campuses more secure. Think about most campuses. If I have classes in the business building, why does that building have to be opened 16 hours a day? Why not have capabilities from Allegion that interface with the registrar's office and it says Chris Snyder is available to enter and exit the business building from 10 to noon? Versus just wide open. There's other examples in terms of people flow, asset utilization. We continue to build every day the connected analytics that can help buildings serve people in different ways, and it's a compelling business case for growth for Allegion.

Absolutely. And I absolutely promise. I promise this is the last one, but I just really wanted to follow up on that. When you see these new companies entering the space who maybe don't have an installed base, maybe haven't been in the space for a long time, in your view, what's the biggest challenge they face in kind of penetrating this market?

So number one, if they come with a software and hardware platform, it's -- one is in the variation. If I need a mortise or a collar or a code, in some cases these take years to develop, so it's the mechanical complexity. And let's say you do have an offering. I build 92,000 locks a day, and 30% of them have chips. Well, how the hell are you going to [ ring out ] when chips are tight? I bet you can't even get them or get in line way behind me [indiscernible] that part of the moat, that part of the complexity that we're very good at that I intend to flex and make sure the customer base is aware that we can provide, I think, seamless access and new ways of satisfying customer needs that is very difficult for a start-up to do.

Well, thank you for that [indiscernible] makes a lot of sense. I know we've gone over but very much appreciate the time. Thank you, Dave. Thank you, Kevin, for joining us today. And thank you to everyone on the line for tuning in. If anyone wants to talk on Allegion, [ feel free to reach out to me ], [email protected]; and then Kevin Sawyer, Director of Investor Relations at Allegion. Thanks again, guys, for the time. And have a good rest of your day.

Hey, Chris, one more commercial: We'll come out of this pandemic faster than we went in [Audio Gap]