Allegion plc (ALLE) Earnings Call Transcript & Summary

All right. Good morning, everyone. Thank you for joining us here at the 9th Annual Credit Suisse Industrials Conference. My name is John Walsh, and I am the multi-industrial and industrial software analyst. Today is December 1st. It is our day 1 of the conference, and we are very excited to start the conference here with Allegion. With us today, we have the broader team, but most of the -- we have Patrick Shannon, CFO; and we also have Tom Martineau and Kevin Sawyer from Investor Relations. So very excited to have the team here with us today and kick off the conference. I believe we're going to head straight into Q&A. [Operator Instructions] It's [email protected]. And if there's time available, I will be happy to ask a question on your behalf. And with that, maybe we'll just dive right in.

So obviously, before we get to some of the more strategic questions that are out there, just wanted to ask if there's any update on how supply chains are kind of fearing. And then just anything to call out here as we're now in December as we just think about heading into year-end?

So nothing really significant in terms of changes. Just a couple of reminders maybe, John, that might provide some context. And as we talked about during the third quarter earnings release, the supply chain issue is difficult and really 2 areas. One would be electronic chips. The other one would be associated with labor shortages with some of our supply base, which means there's delays in terms of us getting our components so we can manufacture and ship to our customers. That hasn't changed significantly. I'd say we've got a pretty good playbook in terms of navigating that in the next year, reengineering some of our product categories so that we can accept dual sources of supply, which will help alleviate some of that bottleneck and work down the backlog in next year. So no, we continue to work the plan. No really significant changes there. I'd say on the demand side, really strong, continues to be strong in terms of the order patterns and those type of things. And obviously, when we report out on Q4, you'll get more detail, but feel good relative to the market dynamics. It's just navigating through the supply chain and provide some good tailwinds into next year.

Great. One of the big questions from the third quarter, and we've also been thinking about it ourselves relative to some of the competitors, is the ability to kind of get price, right, in this inflationary environment. So one of the things I know just -- it's a metric you report. We did see a little bit of deceleration there on the pricing front in the third quarter. Can you just kind of talk us through or remind us what was driving that? I know you guys had called out some mix on the Q3 call, but maybe just a little bit more detail there. And then kind of any actions you've taken since then in terms of pricing?

So there's a lot of dynamics in the pricing situation both on nonresidential and residential. You kind of have to look at the individual pieces, if you will. I think the important part is on the nonresi side, which is the bulk of our pricing piece. We continue to accelerate price there. We just announced another price increase at the beginning of this quarter. More to come early in 2022 as well. So pricing in the nonres side will continue to accelerate sequentially both in terms of percentage of revenue and in dollar terms. So we expect that -- you'll see improvement in Q4 relative to Q3 and then kind of continuous improvement as we continue to move through 2022. On the residential side, a little bit more difficult, obviously, to get pricing in the big-box retail. We do get pricing associated with newbuilder construction and those type of things. But the dynamics in residential, there are speed bumps sometimes during the quarter associated with rebate type of programs, co op advertising, marketing incentives, these type of things, that can change quarter-to-quarter; full year, not a big impact. And so that's kind of what happened in Q3. Nothing out of the extraordinary but just a little anomaly, if you will, in Q3 that impacted the overall price percentage. But I think the important point is that on nonresi, again, the bulk of our pricing movement year-over-year, there is going to be continued acceleration and really, we'll be in a good position to kind of mitigate some of this inflationary headwind going forward.

Great. And then maybe just to make sure I understand it correctly, I think on the Q3 call, that early quarter price increase was about 6%. It sounds like there will probably be more price as we go into next year. Maybe too early to comment on that 6%, but what are you seeing in terms of the actual net realization of these price increases? I mean, is the market willing to accept them? Or are they pushing back? And maybe a little bit more color, I guess, on the nonres side of that part.

Yes. So the 6% was in reference to kind of a cumulative increased list price. And then as you mentioned, there's a net price. There's normally some discounts that kind of come off of that. and when you're looking at competitive bids and new construction projects. Normally, the realizations will be lower than what your list price increase is. So that's kind of 6% cumulative in 2021. There's more to come in 2022. And so part of the issue is you're not seeing all that come to fruition currently because it's backlog-protected, if you will. So it will turn over a period of time in -- starting in 2022. And again, the percentage will increase as we kind of progress throughout 2022 is kind of how to think about that.

Great. And you brought up a really good point there on that price-protected backlog. So that segues right into this next question. How are you thinking about the current ability to get product out of your backlog? I don't know if there was a way to say you typically turned it by so many weeks pre-supply chain and now because of supply chain, which everyone's feeling, that turn has now gone out a quarter or 2 quarters. And maybe that also feeds into that $80 million to $100 million you talked about, but would love to get some context there.

Yes. So we exited Q3 a record backlog. And the backlog we're referring to is really associated with the nonres. Historically, we operate very short backlogs. It's a very kind of book-and-ship type of business. We have the capability to be able to turn that because of our manufacturing excellence. We can do 1 million variants, if you will, and be able to take an order and ship within kind of a 10-day period would kind of be on a historical basis. That has extended out because of some of the supply chain constraints. I'd say it's probably tripled right now relative to where our normal backlog would be. And so it's not kind of a full quarter backlog, but it continues to kind of grow, if you will. The issue is going to be how quickly we can convert that into revenue as we think about 2022 and work that backlog down basis of what I talked about previously in terms of getting dual sources of supply, changing that, reengineering some of our product categories to be able to do that. And so next year, as you think about revenue, there's going to be kind of continued strong demand as we see the market indicators going forward and the activity in the marketplace. And then you have this higher price realization because of the accelerated inflation. And then you've got working down the backlog as well. And so all of those components would kind of accelerate revenue, if you will, relative to historical kind of periods and market demand.

Great. And maybe just, obviously, price is important, but it's price inflation, right, that we usually talk about as 2 parts of the equation. Can you talk to us about how you expect to kind of exit the year on price/cost? And as we think about next year, should that be positive? And is it positive through the whole year? Or do we have to kind of get to the back half to really see it [ in green ]?

Yes. Q3, as you know, John, we were under water in that equation, where inflation given the acceleration there and pricing not able to offset that, and so you had some margin pressure relative to that dynamic. That will continue in Q4 even with our price increases. For the full year 2022, again, more details to come when we report out in Q4 and give guidance on '22. But that equation will be positive. And seeing the gap narrowing as we kind of start the year relative to Q4, call it, but maybe not quite in positive territory early in the year. And some of that's due to the inflation carryover. Remember, early this year, we didn't have the high inflation that we're experiencing today. So you've got high carryover inflation first half of next year. Pricing will kind of continue to mitigate that and then will accelerate during the course of the year so that we're in positive territory clearly in the back half of the year, I'd say, Q2 probably.

Great. And then maybe coming back to supply chains. I just want to make sure I understand the dynamic correctly. Labor has been a pain point for several companies themselves, right, but also either their suppliers have had labor pain points or the end market itself has had labor pain points, finding skilled traits. So you talked about those historical cycle times. I just kind of want to focus in on what's actually impacting that? Is it your suppliers having an inability to hire labor? Is it just stuff that can't get through the ports? So as soon as those containers are unloaded and you get the chips, you can push it out through the factory? Do you have enough labor for that? I'm just curious how fast this could potentially snap back.

So I'd say -- I mean you see it in the newspapers. There's been a lot of people exiting the workforce and/or changing occupations, maybe to be an entrepreneur type of thing. There's an article in The Journal yesterday about that. So you've got people exiting the workforce. Companies kind of going into the pandemic obviously reduced the workforce, and you had a snapback in demand and trying to fill those job opening is very difficult. And so it's predominantly at our supply base is kind of what we're seeing. And that's fueling some of these component shortages in terms of delivery times to us, to our factories. We do have more openings, I'd say, than what we would like basis of the general market in terms of labor shortages. So there's some of that. And I think we will be a little bit challenged next year, assuming we get components on quickly to accelerate our production to work down the backlog, okay? So we're working on plans for that now, so we can take that into account. But I'd say, generally, it's a macro issue, both at our supply -- component suppliers as well as ourselves.

Great. And then maybe you've kind of given us a little bit of breadcrumbs on Q3. You kind of reiterated some of those again earlier when we talked about pricing actions. As we think about the kind of puts and takes on the margins for next year -- obviously, we're still going to have supply chains, but you've historically talked about this 40% leverage, kind of incremental margin. As we think about next year, is that the right starting point? Or do we have to get to the back half of the year to realize that? Just anything that you could help kind of frame that for us?

So the 40%, I'd say, is in a more normalized environment. So think about -- as you build out your model from a margin perspective, there's a lot of inputs that kind of go into that. And what we like to manage the business to manage the inputs, price productivity to offset inflation as well as incremental investments. If you can manage that to, call it, a net 0, our business will leverage on the upside, call it, 40% on normalized times on the incremental revenue, which would give you margin accretion, okay? And so next year, there's different dynamics. Obviously, it's going to be first half, maybe under pressure; second half, I would say, accelerating because you're going to have mix improvement in there. You've got easier comps relative to productivity and efficiencies and these type of things. And so net-net, you would see margin improvement just kind of given the higher revenue, price inflation dynamic becoming positive relative to 2021. There's definitely going to be some margin accretion here. But I would say -- so I will just say on a more normalized basis, 40% is kind of how to think about it. That's an Americas kind of commentary. Internationally, normally is a little bit lower than that, 30% or so. But America is clear at 40%. Tom, you were going to mention something?

I was going to make that same comment.

I guess taking a step back and thinking about some of the longer-term growth drivers of this business, right, there's certainly the LMAC, right, transition. You've been -- I would say -- or I'll characterize it as very active on the new product front with introductions, whether it's the new Schlage NDE or LE Mobile credentials. But would love to get your perspective on how we electrify or how Allegion plays on the electrification of the interior of the building. Because I would kind of argue, and maybe you disagree, the perimeter has already kind of been electrified. And the real opportunity is inside, but would love to get your perspective on that and how mobile plays into that.

Yes. So directionally, you're correct. I mean the exterior of a building is more electrified than the interior. And that's clearly the case. I mean you can walk around and going in any office type of complex, and probably where you're sitting now, and see that. Whereas the interior doors, you have more mechanical locks that provide a good opportunity to electrify that and maybe with a small access kind of control system that enables you to utilize your phone as this kind of a mobile credential type of thing. And we offer those products, and so we see that as a big opportunity. I think the last time we looked at the statistics in the interior of an office building might be under 5% electrified; exterior building, much more electrified. And so you're right in terms of the opportunity. But there's still opportunities at exterior as well. Our strategy has been to kind of continue to take advantage of this secular trend of our industry moving from mechanical to electronics. The financials would say that it's advantageous, obviously, to push that way. You have a higher ASP, similar margin, more EBIT dollars. And so we want to kind of continue to push that. So we're making fairly substantial investments to broaden our product portfolio to electrify entrances, doors, access control systems, software connectivity, all these type of things you think about in terms of seamless access. We want to be the innovator in the market associated with that. And that's where a lot of our incremental investment dollars are being spent today to kind of broaden the product portfolio to electrify entrance and systems and that type of thing.

And then if you were to think about kind of a growth expectations going forward, you have the tailwind from this electrification you just talked about. We think there's going to be a cyclical upturn kind of in construction markets. What do you think the duration of something like this could be? And where do you see the biggest growth within those nonresidential verticals for Allegion?

So I feel the growth is going to be from extended period of time, at least over the next 5 to 10 years easily, again, because of the low penetration in terms of electronic locks, exits, closers, these type of things. And then when you think about connectivity into different types of systems, there's a lot of opportunity here, not only in the U.S. but globally. And so this is going to continue to be a growth driver for Allegion as well as our industry. Our -- we've targeted low double-digit growth in electronics. Pre-pandemic, we were running at that level for both the nonresidential and residential segments of our business and kind of continue to see that as a driver going forward. So I don't think the market dynamics are going to change anytime in the near future. Again, our philosophy is to kind of continue to make incremental investments to accelerate the new product development, getting more products out in the marketplace, integrate our products with more partners that do some of these integrations. Your question is where from a market perspective does that reside? It's predominantly throughout the institutional segments. Think about higher ED, think about K-12 schools, we're a leader in those market segments. We play extremely well there, have a great market presence and would see that continue to grow. Office environment, medical, hospitals, those type of areas, we'll kind of continue to electrify our products, and so see those as good growth vectors for us going forward.

Great. And I guess, as you think about, for example, the education vertical, so there's already been a lot of stimulus allocated for decarbonization, indoor air quality, et cetera, for a school. As they're going through and looking at those projects, is security pulled through with them? Like if they're going to start touching their building systems, do they like to do it all at once? Or are they kind of piecemealing things? So security might be Phase 2 or maybe it's Phase 1? Would love to get your thoughts.

Yes. I'd say, historically, it's probably been done on a piecemeal basis. Maybe there's opportunities to kind of look at things holistically, particularly with some of this infrastructure, monies, incentives the government has put out there. I do believe it will help accelerate some of the growth. I don't think it's a game changer for say. But I do think it helps get people more engaged in thinking about new solutions, electronic security, safety and these type of things in schools, universities. And so it will help fuel that growth. But again, it's not going to be a tsunami of orders. And I think it depends on who's doing the purchasing. Do they look at it holistically, individually? I think predominantly, it's still probably an individual buy on a project basis would be how I think about it.

Great. And maybe broadening the conversation to the industry, we've seen some M&A, right? There appears to be some consolidation happening on the residential side. One, would just love to get your perspective there as you think about your own capital allocation priorities and what you're seeing out there.

So our capital allocation philosophy hasn't changed. You're familiar, one would be organic feed, organic growth through incremental investments, predominantly NPD, engineering, these type of things to drive growth faster than the overall market. We get great returns on those investments, and this will continue to do that. Second would be M&A to participate in the consolidation. And so we kind of continue to look at opportunities to add to our product portfolio. That could be domestically here in the Americas or internationally. We've -- looking at technology will be a bigger part of that, I would say. Yonomi we completed earlier this year to help build out our IoT platform and connectivity into various partners. So things like that. Allegion Ventures, for example, would be another play that we're looking to broaden our portfolio of solutions. So M&A is clearly an opportunity for us. Look at us looking at opportunities that are kind of core to our markets and how we think about that. And then shareholder distributions, either through incremental dividends or share buyback, would kind of be the third component. And we look at that in those order of priorities: so organic investment, M&A, shareholder distribution. So that's kind of our capital allocation. Your question on consolidation in the industry. Our major competitor announced a large transaction in residential acquiring Kwikset. They still have to get through the regulatory hurdles. I don't think that changes the market dynamics. We compete well with Kwikset today. It might actually improve some of the market dynamics there in terms of how that's looked at relative to big box and pricing, those type of things that we'll see. But I'd say we'll kind of continue to participate in the role and consolidation of our industry and looking for opportunities to add to our product portfolio domestically and internationally.

Great. And maybe just thinking about some other uses of cash, I guess, more on the organic front. But one, how are you thinking about your CapEx spending into next year? And I'm kind of curious on the angle of resiliency and if there's any kind of automation investments still to be made. And then maybe a follow-on to that is, how should we think about working capital? I mean, are you thinking about going out and carrying a higher inventory balance, right, just given what we're seeing with supply chains?

Yes. So working capital, historically, we've operated, we'll call it, 5%, 6% of revenue, so fairly low working capital requirements. You could expect in pockets of our business where we're going to make some incremental investments to carry more inventory. I think particularly as you think about operationally, historically, we've been on a just-in-time kind of manufacturing base, supplier-owned inventory at our factories. And we may want to beef that up a little bit and carry our own inventory for backup and those type of things. And we've done some of that this year on purchased components. So our inventory has increased a little bit year-over-year. So that's something we'll continue to look at. I don't think it's a huge step up in terms of additional capital requirements there. CapEx, historically, we've operated, call it, 2% of revenue, so $50 million, $60 million-ish type of number. I'd say there's opportunities probably to step that up a little bit, predominantly on the productivity side. There isn't a need or necessary for significant capacity step-up requirements to meet demand type of thing. And so it's mostly on, hey, how do we fine-tune our operations? How do we think about that? Engineering, software development, would be another area where you have some capitalized software, and you carry those costs. So we'll continue to look at that. But again, it's not a significant step-up relative to where we've operated historically.

Great. And I guess just looking at the time, we might have to end it there on that. But once again, I'd just like to say really appreciate having Patrick and the team here today. And we hope that everyone stays safe and well. So thank you all for listening.

Thanks for having us. Thanks for having us, John. Appreciate it.

Great. Take care, everybody.

Bye. See you.