Allegion plc (ALLE) Earnings Call Transcript & Summary

Good afternoon. I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for day 2 of our 9th Annual Laguna Conference, virtual this year, of course. And we're pleased to have join us today the team from Allegion. On the line with us today, we have Chairman, President and CEO, Dave Petratis; as well as Tom Martineau, Treasurer and Vice President of Investor Relations; and Kevin Sawyer, Director of Investor Relations. Before I turn it over to Dave to make some opening comments, I do need to remind everybody that for questions about our research disclosures to please visit the appropriate website at morganstanley.com/researchdisclosures. And for all other questions, please reach out to your Morgan Stanley salesperson. With that, Dave, thanks for joining us, as always. Sad to see that it's not in Southern California, a place I know you're very familiar with, and we love to call home for a few days for our conference every year. But good to hear your voice all the same.

Well, even virtually, it's good to be with you, Josh. In my mind, I can see the Newport Coast, and I look forward to the days that we're together to see that. I think some opening observations, collectively, we've all been part of this pandemic for the last 20 months, my commitment to our shareholders, the employees of Allegion and our customers is that the company would exit the pandemic stronger than when we entered. I think 12 months ago, we were talking about the early innings of the pandemic decrementals. And I think as we reflect back on the first 20 months of this, our decrementals in terms of revenue and operating margins held up extremely well as we navigated the first leg of this. I think as we go forward, I don't see the pandemic going away. The ebbs and flows continue to work. But I think the infection -- the mutations and infection is something we're going to have to navigate for the foreseeable future. And hopefully, it mitigates over time. But I think we're moving into the winter months in the Northern Hemisphere, and it's going to continue to be a challenge. The pandemic has had some pretty significant impacts on supply chain from the beginning, the global supply chain. And I think one of the key drivers has been labor scarcity. Here in the Americas today, 10 million job openings, 8 million unemployed. It's just the math of it says there's a problem with labor availability in the market. There's an undersupply of chips and electronics. Logistics are aggravated and it cascades into all elements of business, construction and has fueled inflation in which public officials would say inflation is going to be transitory. I believe inflation is going to be with us for an extended period, 2, 3 years, and preparing and positioning Allegion to make sure that we mitigate those inflationary forces and it's not a transitory situation. The company has had a heavy focus on ESG. I appreciate shareholder inputs. We continue to drive that. At the base of our ESG efforts, we think it's important that Allegion run a strong business, and it gives us the opportunity to lean in to environmental, social and governance issues and areas that we lean on. We also think during the pandemic, we have invested to better understand our opportunity of seamless access, building our software stacks that will advance connectivity and continue to be a driver of Allegion growth over the next decade. So as I hand off to you today, Josh, I think Allegion has navigated well. Our future has never been bright. We're facing some supply chain challenges. And I think our record of the last 20 months will be indicative in our adaptability to be able to change with that. I'm pleased to say that market demand overall is certainly at 2019 levels. And I think particularly in the res and commercial institutional markets, with a slight headwind of the supply chains, good demand ahead as we pull out of this pandemic. So with that, I'll turn it over to your questions, Josh.

Awesome. An excellent kind of table setting there. I guess maybe to pick up on a thread that you laid out in 2Q with the quote activity really starting to pick up. Obviously, there's a lot of bottlenecks in the system. You mentioned some of them. Does that provide you more visibility into '22 than normal? So sitting here today, I think there's optimism in some of those markets, you mentioned commercial and institutional, and I think particularly on the institutional side. Are we really at this point sort of building the funnel for next year versus seeing a lot that is necessarily able to be converted in the near term?

So our quote spec and book activity is extremely robust. And I'd point to the strength of our backlog, our ability to push that through because of the supply constraints is going to be limited. I think that sets us up nicely Q4 and the first half of next year. I think you also got to then switch to the macro drivers. The infrastructure stimulus has a pretty good element on markets that are important to us, K-12 and institutional. I think you still have that pent-up backlog of small projects and preventive maintenance that were delayed. I think in the commercial institutional side, today, we see a replenishment of wholesaler and contractor distributor [ shelves ]. And again, the supply chain being a headwind, but I think the commercial institutional markets, driven by a lighthouse called ABI, is looking good for the foreseeable future.

Got it. And you mentioned kind of being back at 2019 levels of demand in the marketplace. Obviously, it's a different thing than revenue. I think if you look across the totality of your portfolio, that makes sense. But would you say that's the case in institutional and in commercial individually as well that those sort of get back to the run rates we would have seen pre-pandemic, which I think we would also say is kind of a healthy nonres environment? So hardly a low starting point.

Yes. Remember, we actually went into 2020 with record revenues. So we were strong. We wrote that backlog. But in particular, K-12, college campuses, hospitals continue to be robust. I've been skeptical, especially on the commercial office. Hospitality, not necessarily in our sweet spot, but we benefit commercial. I've actually become more optimistic, though people aren't returning to the office, but those spaces are being redesigned, repurposed to more open, to more touchless. And I think even with occupancies under pressure on an office standpoint, money will go to recreate this and repurpose this and it will be a net positive for Allegion.

Are you starting to see the K-12 kind of COVID relief investment -- I sort of forget the nomenclature at this point. Are you starting to see that money flow? Or is that still kind of in the design and specification phase?

I'd classify it in a couple of ways. Number one, the spec bid activity is moving. One of the big time periods for K-12 is the summer season, and it's certainly rebounded. But I think we'll also see strength in the summer season of '22 because you lost '20 and you lost -- or certainly '21 was diminished. So you've got that backlog of projects, and we clearly see the construction activity moving, but the sweet spot of that activity, especially in the repair/retrofit is May to August.

Got it. And you mentioned the office recovery not necessarily being quite as correlated as return to work as what you thought. I think that's sort of a surprise for me as well to hear that. Is that something that you've seen sort of ebb and flow with caseloads, like the Delta variant shifted course on that? Or is that sort of in a more steady progression since we started the year?

So I want to make sure I put the proper color on this. As we went through 2020, I actually thought the commercial office segment would be significantly more difficult. We see projects that are repurposing part of that. We see reconfiguration that provide more social distancing and touchless. I wouldn't say it's a gold rush, but it's better -- I thought this was going to be a [indiscernible] and it's actually had some light.

Got it. Maybe just another thing on the demand side that's come up a lot and admittedly in different vectors besides security, but this whole convergent building, integrating multiple systems, creating more smart buildings, has that come your way in terms of smart access as well? And anything you could share around where you think penetration is on some of your convergent technologies today in the marketplace might help kind of set the framework for where we could go in the future there, too?

So a couple of different perspectives on it. Through the pandemic, Allegion has been investing heavily in our software stacks to be able to provide APIs and SDKs, software development kits, and application interfaces to be able to partner with integrators to be able to be a more aggressive part of that conversion. Examples would be Auburn University, where recently, Tim Cook, the CEO of Apple, talked about our partnership and integration on that site as part of that overall convergence. My strong point is you've got to have that software infrastructure to be able to be the partner of choice and have the products that allow that seamless access. We see that trend continuing and will be a, I think, a more important dynamic as people enter and egress buildings with the use of digital devices, I think the APIs, SDKs and our unique position on the door open up opportunities for recurring revenue that will allow Allegion to grow. Another example of a partnership would be Openpath, where we're fully integrated. That asset just sold to Motorola, but technologies that we identified, invested in and partnered with, that will help our bottom line but it's really a partnership. Openpath looks at the world of access from a different lens from Allegion being able to monetize information to be able to make not only access, but the utilization of assets that drive ROIs. And we think we have strengthened Allegion's position, and we'll be able to benefit from that electronic convergence that's going on, both res, commercial and institutional.

I think admittedly though, the starting point is still low today, so a little bit goes a long way. Where do you think some of this technology is penetrated in nonres as we sit here now?

I'd say we're in the early innings. I can cite the examples of Openpath and seamless access tends to be heavier on the commercial. But Auburn University, a very recent example, hospitals, college campuses, even K-12, security as well as access can be enhanced through the use of digital tools, digital access, what we call seamless access.

And how would you characterize the price differential? I think, historically, especially when Allegion first came public, there was sort of the idea that these things were a lot more expensive. Price points were higher. Margin was fairly similar to maybe the core portfolio or the mechanical equivalent. As you've seen more growth, more adoption, more complexity, how has that price differential evolved over time versus the mechanical counterpart?

I'd say our electronic platforms have been a steady state with similar margins to our mechanical locks with a higher average selling price. And it's true in both res and commercial institutional. It's a good value proposition as we enhance the connectivity, the battery life, these APIs and SDKs, it's net margin plus for us at Allegion.

Understood. I guess looking at that through the residential and most residential markets have had really solid go of it for the past 1.5 years. You guys have been no different notwithstanding some supply chain challenges, particularly early on. How has the inventories and what you can tell on point-of-sale demand trended as comparisons have gotten tougher?

So we continue to have favorable point of sale. I think our backlogs have normalized. If the backlog had any differentiator, it would be a little bit more heavy on electronics because of some of the tight chip supplies. But I believe if you take 2019, '20 and '21, there's a net market share gain by Allegion. It's because of the strength of our supply chains. They're more local to our dominant American market and builders. The big box came to us because of the reliability of that supply chain. I think it's allowed us to gain share. I think we continue to enhance the portfolio of products. The Schlage Encode is the #1 seller and thousands of reviews. It's, again, the ease of integration with the configuration customers want, long battery life, which is important. And we've got some technical capabilities on its Wi-Fi connectivity that give it long battery life that differentiate us as the product of choice. That has helped us not only to gain share, but also to benefit from the strong resurgence in single-family homebuilding. We picked up some good accounts, bundling leading electronics with our strong suite of mechanical capabilities.

Anything gives you particular confidence or insight into this category in particular is not having some sort of pull forward that sets up a tougher comp later in time? I mean I think other industries that are sort of more failure-driven perhaps than residential can at least point to, hey, things will always break, but there is some level of discretion driving these upgrades. Anything that you see in the channel here from customers or data you look at that gives you that confidence that this can be sort of a new normal on the residential side?

McKinsey would look at this market in terms of IoT adoption and say it's accelerating. One, what are the drivers of those accelerators? It's that millennial group going into the housing market, which has boosted it. They want to deal with keys. I think you also have the long-term benefits. The lock on my mother's house, my mom would be 95, is still the same keylock. When a millennial buys that house, they're going to upgrade it to electronics. Given the ability to control access, I like the long-term drivers. I think U.S. home start's at $1.5 billion because of the undersupply of inventory is a great long-term driver for at least the next 5 to 10 years.

Got it. That's helpful. Maybe just pivoting over to kind of the topic du jour and certainly very relevant over the past few days here on supply chain. You guys have seen your fair share of this going back to 2020. You mentioned chips are still a little bit in short supply as it pertains to the electronic side of resi. But overall, how would you characterize the supply chain environment ex things like contractor waiver as having any kind of influence over the business today or ability to meet demand?

I would describe the supply chain environment as challenging. And you got to put this in context. I had 2,500 workers locked out of 3 plants by the Mexican government. So it's not as intense as that, but it's -- the supply chain across the spectrum is under pressure. I think chips is a separate category. I'll talk about this, but there's labor constraints that affect logistics, component supply, availability of workers to go into our factories as demand increases. On a normal day, Josh, I would say, complexity is our friend at Allegion. And that complexity drives our industry-leading margins, but the complexity under supply chain pressure, I can have a $0.05 [indiscernible] or a power supply or a chip that if I can't get, I can't ship that complex item. So again, I think Allegion's got a great ability to adapt to this, but we're not untested. As you go to chips, I've got a growing business that's reliant on chips. I think the chip challenge will be with us well into 2023. Again, I applaud the Allegion adaptability. We've taken some of our largest electronic products, the KPD and KPL, and reconfigured those boards to accommodate new chips at a pace that is 50% less than would normally be developed. So it reinforces, as we come out of this, we'll be stronger. We'll think differently particularly about these chip supply lines. But again, that adaptability, those products are flowing because we've made those changes. We've got more work to do there.

Understood. And then I guess just thinking about the price-cost environment, I mean, essentially, everything has become more inflationary over the past, call it, 90 days. Allegion has a good track record over time of offsetting that on a dollar basis and sometimes margin as well. Any more, I guess, pressures that have mounted there that add to that for the second half and sort of set up more price needs for 2022?

Yes. Hey, Josh, this is Tom. We'd say that coming out of Q2, we said exactly what you were referring to, the idea for second half after the first price increase and we actually had a second price increase going in effect this October would be to effectively cover the material inflation pressure. And then it probably wouldn't be able to cover margin rate, right, because you're increasing the price recovery in the dollars. But as you turn, depending on what happened with inflation getting to '22, you'd like to see that get back to a normalized recovery where you're actually looking at covering some of the margin rate. We would say inflation has persisted. We'll continue to monitor that. That would give us the thoughts that how are we going to address we'd look out maybe to the normal April price increase. Do we need to pull that ahead a little bit? What that magnitude would need to be? Probably a little early. When we come out with our Q3 earnings, we'll be able to give you an update on that. One area we have seen probably increased pressure would be around freight, and that's just also tied into the supply chain. But the freight inflation is one where we're addressing usually through more of a surcharge route. That's usually indicative that the market will accept it, but expect that it would ebb or come back when the inflationary pressure and supply chains normalize. That's just kind of a normal way. So we'll approach it that way. It's also the way we handle maybe the large steel where we have large steel use, let's say, in our hollow metal door frames business where we'll actually look at steel surcharges on top of the price increases, just to cover for short duration with the expectation of the market to go back. So usually, we like to think we operate in a pretty disciplined market -- disciplined pricing environment. We have shown that ability to get the price. We'll continue to manage that. Probably a little bit of pressure as we go through the rest of this year though on the rate, and then we'll see where we are in '22.

I want to summarize it, Josh, for our listeners, 2 price increases in 2021. On metal and freight we're pulling surcharges. Allegion over the last few years have invested in price analytics that there's multiple ways to pass price. And I think we have shown that we can pass price net of inflation and drive margin expansion. We may have some ebbs and flows in that because of the veracity of how prices have gone up, but I think we're well positioned for the long term to mitigate and benefit from the effects of it.

Understood. If I recall comments made earlier in the year about sort of an unrelated margin item, but a margin item all the same around investments, that '22 -- I'm sorry, '21 was a little elevated. You found some opportunities to pull things forward. Should we still think about '21 as being a little higher than the normal year on investment with some room to normalize as we get into next year? Or have you found more things to prioritize here in the medium term?

I'd say our general view today is '21 will be a bit elevated. We're reviewing our strategic plans and investments for '22. And if there's a change to that, we'll advise, but I think you've got it right that it will come off. What have we been investing in? Heavy around new software stacks, we had several -- 3 to 5 new introduction of products slated to come out now to the first quarter of '22. A bit challenged by the chip supply, which we're going in and adapting that. But barring any moves, we would see that investment spend to come down a bit as we move into next year.

Got it. And then I guess specifically on the international side, margins there have really been exceptional. And I know that some of that is combining the organizations in EMEA and Asia Pac. Is there a path for margin expansion from here based on some more kind of cost reduction and removal with that organizational realignment? Or does it kind of reflect more of what you have in the Americas, core execution volume, things like that?

I'd say a couple of things. We're in the international segments over the last few years. I thought the combining of the 2 units helped management to focus, it helped extend some of the capabilities we have in the Americas to the other regions. Tim Eckersley has really done a nice job with that. And I think the path there is really predominated by our continued success in electronics. Interflex, SimonsVoss, those businesses are growing at high single digits. So you've got some cost [ rip-out ], but you've also got a better mix, some price realization going on in our [indiscernible] business. There's a third element in that equation, and that's the Australia and New Zealand business, which we think is on a track to recovery. We acquired the market leader, Gainsborough. At the market peak, we see the incentives going into the Australian market that will spur housing. That will be good for our margin and growth in that region. So focus on electronics and the geographical areas where we can win is part of the equation of success in the international groups.

Got it. And then just sort of pivoting outside of the core of the business, but something topical all the same. You have some congressional proposals out there on foreign domiciled companies. What should we think about as kind of the key sensitivities in Allegion's tax rate? I know a lot goes into the soup there. It's not just one lever that gets pulled. But based on some of the proposals out there today, how would you view kind of the width of the aperture on what the impact could be?

Yes. So Josh, as you know, we're not -- we're susceptible if there's changes to the U.S. tax code, right, given our U.S. operations and earnings. So we monitor it. We would say that there's quite a number of different proposals going through right now. I mean as many senators as there are, there's almost that many types of proposals. So you could get into a circular pattern here of analysis, death by analysis just trying to do everything. We'll -- we continue to monitor it. We'll look at the ways to navigate this appropriately. And as we learn more, we'll be able to communicate that as we go forward. We've got third-party support as we go through this to understand it better. But again, probably more information as it becomes clear, what's actually being put out there.

Understood. I appreciate it.

Josh, I would remind you that we're second generation Irish.

Understood.

Ingersoll Rand was Irish and we're second generation.

Big family tree there now, too.

Yes, that's right. Yes.

I appreciate the time, guys, as always. Thanks for joining us. Hope to do it in a better location and more sunlight next year. But appreciate it all the same and be well in the meantime.

[ You ] too, be safe. Thanks, Josh.

Thanks.