Allegion plc (ALLE) Earnings Call Transcript & Summary

Good morning, everybody, and thank you for joining us at Baird's Global Industrial Conference. I'm Tim Wojs. I cover residential and commercial building products here at Baird, and we're delighted to have Allegion again with us this morning. For those of you who don't know, Allegion is the largest mechanical security provider in the U.S., and they've got a growing portfolio of electromechanical offerings and a very strong competitive position in their respective markets. Joining us from the company are Dave Petratis, Chairman, President and CEO; Patrick Shannon, SVP and CFO; and then Tom Martineau and Kevin Sawyer from IR. In terms of format, we'll have Dave give us some prepared remarks, kind of a state of the union, and then we'll run through some Q&A. Feel free to e-mail me questions at tim -- or [email protected]. And I'll do my best to get to those as they come in. So with that, Dave, I'll turn the floor over to you.

Good morning, Tim. Good to be with you for my 13th Baird conference. It's hard to believe time goes that fast. But believe me, Tim, we were both better looking 13 years ago. The state of Allegion, maybe some opening comments, extremely proud of the Allegion business performance through the pandemic. We're 20, 22 months into this, and I think the company has navigated well. My commitment to shareholders, our employees and customers, that we would exit the pandemic stronger than when we went into it. I think the growth throughout this pandemic cycle is noteworthy. I think some of the changes that we've made in forming Allegion International noteworthy. And we continue to invest in software capabilities, what I would call software stacks that I think are really opening up new opportunities in the world that we define as seamless access. And important as we believe the security industry as well as Allegion, tremendous opportunities as our edge device, our cell phones, smart edge devices become access points facilitated by electronic locks and then software capabilities, both on the res, commercial, institutional stacks. Our acquisition of Yonomi earlier in the year, our partnership with Yonomi over the past has really beared some fruit that we think common software stacks available globally to partners, our own products, that will differentiate us going forward. So we feel good about the long-term growth aspects, the seamless access. I'd also note, Allegion continues to advance on a variety of ESG opportunities. Last month, we were recognized by the National Safety Council for the Campbell Award, 5 years of performance to be able to qualify that -- for that award on environmental stewardship. The health and safety of our employees, the foundation of health and safety was really a catalyst for our performance through the pandemic. We had built a strong relationship with our workforce that we could keep them safe and healthy. And that really came to fruition, which I think kept our business operating through the difficult dark days of the pandemic and will show its resiliency again as we fight the supply chain challenges. Labor attractiveness, Allegion is a very good place to work. ESG and our own performance would be a good indicator of that. So we'll exit this -- these challenges stronger, Tim, and I feel good about the position of Allegion.

Okay. Okay. That's great. I mean as you think about -- maybe just like step back and you think about just kind of the nonres market and kind of how you kind of see maybe the cycle developing over the next couple of years. I mean it sounds like quoting activity in the market is pretty good. But then you also have kind of the lead time between quotes and orders and kind of when that gets shipped. So how should you -- how should kind of investors or how would you kind of frame how you think the nonres cycle plays out this time over the next, call it, 2, 3, 5 years?

I think the nonres cycle in the North American markets are going to be extremely strong over the next 3 to 5 years. Number one, accelerated or benefited by the recent infrastructure bill that passed over the weekend. Two, the pandemic, we saw a heavy drop in the repair/replacement in projects, small project part of the business. That's still unpacking and we see that in our current backlog and order rates. And the third, you look at the macro drivers, K-12, college campuses, hospitals and the need for investment, capped with some of the strongest ABI that we've seen, I like the momentum. I think it's challenged a little bit. It's challenged by supply chain, but more importantly, challenged by labor and labor scarcity from professional jobs, trade jobs, factory jobs and white collar jobs. There's labor scarcity around the world, and I think it takes a very strong recovery and extends it probably for the next 5 years.

Okay. Okay. And can you, Dave, as you kind of look at -- just a little bit of thought around kind of what the pandemic means for some of the bigger cut in nonres vertical markets over time. I mean do you think there's going to be an elevated kind of replacement or renovation cycle that kind of similar to what you see in the residential side, there's a lot of turnover in terms of tenants in office space and those types of things. And even though maybe office space shrinks or something like that over time, all that kind of movement is going to create a renovation opportunity for somebody like Allegion.

I absolutely like the opportunity on the various forces that are working on the segments that are important. If you think about commercial, retail, office space, there's going to -- these spaces are going to be repurposed. There's the capital availability out there to go in and reinvest and redefine these spaces. I like Allegion's opportunity there. It will require, number one, just replace and retrofit depending on how they're restyled and repurposed. You also have like there'll be malls that are just leveled and rebuilt with new means of delivering the goods and services. Logistics would be a good example of that. Logistics warehousing booming across the world, that is because of package deliveries that are exploding. I think third, going into this, K-12 infrastructure still has about a 40-year average, the infrastructure age, 40 years. You still have all the security threats. You have the desire for seamless access at both the college campus and K-12 security. We saw in the recent elections, bond issues, again, with Americans want to invest in school infrastructure. So as I think about commercial retail repurposes, K-12 needed infrastructure investments, college campuses continue to be redefined, and then you move to the hospitals that maybe have some of the most severe tests in our lifetimes because of COVID, you've got to like the business opportunities there in terms of access, complemented by the evolution towards electronics, seamless access and Software as a Service.

Okay. That's a good overview. A good segue into my next question. Just how do you -- how is Allegion positioned today from kind of the shift towards seamless access and kind of leveraging your, I guess, front-end infrastructure around specification to how you're kind of positioned today? How do you see that evolving over the next 3 to 5 years in terms of your product offering and what you might need to go out and either create or maybe acquire inorganically?

So one, investments in the front end with a suite of capabilities that we call Overtur that digitally link our capabilities to architects, specifiers and contractors. It's a digital suite of capabilities that allow an architect to engineer something like SoFi Stadium where the Rams and Chargers play, and the ability to digitize that. Any young person coming out of a college campus today wants to work in a digitized world, Allegion and over $30 million investment to create that opportunity, and it's well received by customers. But it also digitized the life of that structure. So 3,000 openings at SoFi Stadium in Los Angeles are digitized, it opens up new avenues of productivity for us and customers. And think about if you have a break/fix at any entrants in that stadium, you know what's there. So not only facilitates action in the specification and quote, but for the life of that project, including like work that may go up with safety officials. If I want to evacuate that, I can simulate flows. So we like the investment there in terms of the front end. Second, throughout the pandemic, we've invested in our software stacks and think about our residential stack, our software that drives our Schlage apps, give this partnership capabilities with an ADT and Alarm.com or any security provider, the Schlage app and that capability has some of the highest rated capabilities within the industry. And then you couple that with other software investments or stacks that build on the commercial institutional capability that allows Allegion to partner in our open platform strategy with any tax integrator that's requiring our capability in more complex systems. Our acquisition of Yonomi and partnership with Yonomi are investments and are substantial. We've added or doubled the engineering capability over the last few years, and that's coming to fruition where we can have a common software stack extended anywhere Allegion is in the world. That's different than when we went into this pandemic. So I like the investments front end, our capability. And then we continue to release new product sets that enhance the durability, the connectivity, that's important. Not easy for a company, a mechanical company with a 100-year roots to move electronically and into the Software as a Service. I think we've done a nice job with it. An element that investors might miss is the ventures activity. We disclosed in our third quarter some nice returns on our venture activity. It's another way to partner and put our toe in the water versus writing big checks [ where we own ]. I like the way that we're moving through and embracing the technology, and it will help us grow in the future. A lot to unpack there. A lot of exciting things happening.

Yes. Yes, I know. I mean how do you think about -- I mean, as buildings kind of evolve, I mean, what's -- how important is it to be, I guess, put more irons in the fire and kind of -- versus picking a winner today in terms of how the market develops. Because I mean some -- there's some companies that are kind of consolidating around kind of a total building solution and there's others that are still kind of on a best-of-breed path. So how do you see Allegion kind of fitting into that kind of ultimate development of how the building -- how a lot of the building services and building products kind of migrate over time?

So I've lived this total building solutions. And we certainly, in the last 2 decades, saw General Electric, Schneider, Johnson Controls, Siemens trying to go down that path. And my observation would be, it would be difficult for Allegion or an Eaton, a Schneider, a Johnson Controls to cover at a high level of capability all the needs inside of building because they're diverse. Temperature, air flow, security, fire, I don't see and have never bought in that one player can deliver that. Allegion's focus from the beginning has been to provide open platforms. So if customers want a unique access security solution that might serve us 100 openings, we can provide that and then have the capabilities that if we want to partner with tax OEMs, let the customer define how they want the technology to move and make sure that we've got software stacks, APIs, SDKs that allow them to seamlessly integrate with Allegion.

Okay. Okay. Understood. I guess maybe on the specification side, it doesn't get maybe as much kind of focus because maybe it's kind of taken for granted. But could you just talk about the advantage you have in terms of kind of your specifier business in that kind of front-end investment relative to maybe some of your peers or maybe some of these kind of emerging technology companies and how that kind of differentiates you and gives you an advantage in the marketplace on the front-end specification part of the business?

So Tim, as I think about our specification strength here at Allegion, I want investors to be very aware that these specifications are extremely complex that involve a variety of building codes, exit, entrance, fire, active shooter. These are not minor and the capability that we're managing is really complexity. If the needs for an opening at O'Hare to go on to a jetway are different that if you're going into an emergency room through double doors automatic. So the specification part of what Allegion delivers to architects and contractors is complex. We have one of the largest [ step-writing ] teams in North America. The experience there, to become a specifier is like learning a foreign language. And it's everything from door materials to hinges, to closures, to locks, to master key systems. Now integrate that with software and electricity, it's like learning a language. We have one of the most experienced basis. We've made investments that I talked about with Overtur to help augment that. And it's something that's not easily duplicated and one of the strong moats around the business.

Okay. Okay. Good. I guess on the -- maybe kind of switching gears a little bit to the residential side. Could you talk about kind of where you see that business kind of developing from here? Obviously, some benefits from kind of stay at home and COVID and some inventory restocking. But how do you think of that business kind of growing off of this space? And I think it's a pretty good business, kind of absolute terms, it's not quite as good as the nonres business, but -- from a profitability perspective. But yes, I guess how would you kind of frame the opportunity on the residential side over the next 12 to 18 months with developments going on?

So I like the trends that are progressing in the macro residential environment. As I think about housing, 2008 to, let's say, 2018, 2019, we were underbuilding housing supplies in this country. So there's a deficit in single-family homes. The existing infrastructure has got major renovation and investment going into it. It will take, I would say, the next decade if we build 1.3 million, 1.5 million single-family units to get existing inventories and balance. So you got to like that. The second is the retrofit. Schlage is the #1 replacement lock on the market. We perform extremely well in that retrofit, have been investing in the new build. And then electronics and access also become an important part of this. If you go to the April review by consumer reports, 3 of the rated 8 electronic locks were Allegion locks under the Schlage brand. So differentiated by the user rating of our apps and its integration ability, battery life and then the traditional strengths of the Schlage locks that differentiate us. You may remember, Tim, on stage, I think it was 2015, Allegion unleashed the first voice-activated lock on the market. We continue to, I think, have good differentiation and I think are thoughtful and mindful of how electronics can enhance security, but if not properly applied, can detract from it as well.

Okay. Okay. How do you think about -- I mean, obviously, you have kind of the exterior kind of electromechanical opportunity within residential. Are there other kind of adjacencies that are -- can get kind of the seamless access on the residential side? I don't know if that's a garage door opener or patio doors or other things like that. I mean are there opportunities for Allegion to kind of get into some of those adjacent markets?

Absolutely is. I think, number one, investors should realize typically, there's 3 exterior openings on a single-family home. You've got to like that. Second is the opportunities in multifamily. There's a very large installed base of multifamily apartment dwellings that are key. As you get into the larger comp -- the larger complexes, you've got things that software can enable. And this is where Software-as-a-Service package can enable an operator to manage tenants, move in, move out, package delivery, gate operators. Our software stacks allow that integration and can provide an ROI to an operator in multifamily that can help us grow in those adjacencies. I would also say, whether it's gate operators, garage door operators, sliding doors, other types of storage units, all of this will be accessed electronically and opens up a nice opportunity for our industry and Allegion.

Okay. Okay. Maybe thinking about kind of flipping over a little bit to the margin side. Obviously, a very dynamic environment, a lot going on with inflation in the supply chain. But the margins are probably, I think, the math is in kind of 25%, 26% in the Americas this year. How do we think about kind of getting back to that kind of 29%, 30% level that you were doing pre-pandemic? What are kind of the key buckets to kind of retaking that margin ground?

Yes, Tim. So I would characterize it this way, as you said, challenged this year, given the acceleration of inflation. Pricing not mitigating that right now, but sequentially, will kind of continue to improve. And at some point, given the pricing actions we've taken this year plus what we anticipate next year, there'll be a breakeven and then a further kind of divergence if you assume inflation kind of stays where it is now. So as I think about the margin profile going forward, the key factors that would kind of accelerate margin accretion from here going forward and enable us to reach kind of a peak margin or return back to, call it, 2019 levels, 29%. So pricing exceeding inflation. I think we control that to some extent. As long as inflation stays put, we'll continue to push the lever. We've done that successfully in an inflationary environment and deflationary environment and well-disciplined industry, as you know. So I think we can kind of help accelerate that piece of it. We'll continue to drive productivity would be another item. Third would be kind of given the strong backlog and the fact that, that backlog is margin-rich products in nonres, when that continues to alleviate and we get through some of the supply chain challenges, that will provide a favorable margin mix into the situation there, particularly for nonres. And then just kind of your continued volume leverage relative to the market dynamics, which we've always done fairly well on, all those characteristics would suggest margins increasing from here. I think it's going to -- next year, it's not going to recover 300, 400 basis points. But over a period of time, call it, 2 to 3 years, I have no doubt that we can get our margin profile back to where it was on higher revenue dollars, okay, which means more OI dollars. So I feel pretty good about that. And then the question is, where can it go from there? And our philosophy has always been, hey, manage the inputs, the things you control, price productivity offsetting inflation and incremental investments. And to the extent we can do that given the high contribution margin, you would expect that the margin profile would lift on incremental volume. So that's kind of the model. And we've got a lot to execute, okay, and kind of get the supply chain issues behind us going forward. But I think we're positioned kind of given some of the dynamics as long as there's steady, or call it, inflation doesn't increase from here, then it's capped. Then we're in a good position to start showing incremental margins going forward.

Okay. Okay. That's good. That's helpful. And then maybe just 2 follow-ups to that. I mean the first on pricing. Any -- I mean you've always been able to kind of regain kind of inflation, and you could go back and run through your filings and show that, that always kind of turns positive. Is there any kind of change in your confidence in that ability going forward? It doesn't sound like, I just want to confirm. And then the second is just around the supply chain, I mean, how comfortable do you feel that you have the actions in place today to mitigate those challenges over the next, call it, 6 to 9 months?

So on the pricing side, I'd say my confidence level hasn't changed to be able to mitigate it. But it's longer, okay, because of the backlog and as you know, we're -- some of the backlog is price-protected when we received the order prior to the price increase. So the opportunity to mitigate inflation is kind of pushed out a little bit further than what we've seen from historical periods and rising inflation. And so the breakeven point will take longer to achieve. But nonetheless, I mean, there's going to be a convergence, and there's going to be improvement relative to price inflation dynamic. The only caveat I would say in that is on the resi side, given the accelerated inflation, a little bit harder to mitigate that, particularly in the big box retail segment. And so that puts a little bit further price inflation dynamic than what we've seen historically in that segment of the business. And then on the supply chain challenges we face, I believe, kind of when I look at our actions and the resources we're putting behind it, the number of engineers we put in terms of redesigning our products to be able to accelerate alternative sources of supply, whether it be electronic chips or other components, I feel like it's being executed well. It takes time to implement the changes. And some of it's going to be contingent upon how quickly can our supply base get labor to get us the products we need. So some of it we control, some of it is third party. But I believe relative to the things that we're executing on, I feel good relative to the plan we're executing on.

I would say on supply chain, as you think about Allegion, I think we've been highly adaptive to counteract a variety of forces and need to think sequentially, it will mitigate quarter-to-quarter with electronics and chips being the longest tent in -- the pole in the tent. I'd say the other thing that's unusual in my 41 years is labor scarcity around the world. And I say around the world, it's different pockets, but from labor, skilled trades, professionals, there's some big shifts going on. I think there's a high level of adaptability. I think Allegion, a very attractive place to work. But as you get into the complexity of our supply chain, I have to depend on those suppliers to be able to bring in labor as well. And we're extending out to that, but it's certainly an unusual time for American manufacturing and business at large.

Okay. Okay. Understood. So I think we're about out of time. So I thank you guys for joining us in this session and appreciate the discussion. The management team is going to be available for a 15-minute breakout session after this presentation. The next companies presenting will be Generac, Littelfuse, MSA Safety, Comfort Systems, AAR Corp., Aptar Group and Terex. So thanks, Dave, Patrick, Tom and Kevin, and appreciate your time.

Thanks, Tom.