Allegion plc (ALLE) Earnings Call Transcript & Summary

Okay. Thanks so much. This is going to be the last of our morning sessions, but we have more because then we'll have afternoon. So with us, we have the team from Allegion. And I will present today is Mike Wagnes, Company Senior VP and CFO. And we also have on stage Tom Martineau, VP, IR. And I've had pleasure to work with both of them for many, many years. And with that, I'll join them on stage and we'll go straight to the fireside chat. And it's always, always a pleasure to have you guys. Thank you.

Thank you, Andrew.

Okay. And for folks in the audience, feel free to sort of submit your questions. So question one, so Mike, you are the new CFO. You've been on the office side. So what have you observed as areas where Allegion is doing well and what areas have room for improvement? You formally led Commercial Americas business. What kind of expertise and lessons learned can you bring from that to entering your role?

Thank you. So just to introduce myself, Mike Wagnes, CFO, recently named at Allegion, but I've been here for a number of years. I came out 12 years ago to Allegion when it was part of Ingersoll Rand. And I will tell you, if you think about Allegion's strength, our strength has always been in that nonresidential North American market and business. We also have a strong residential business and then improving international business. So if you think about where we're really strong, we're really strong in that North American but improving internationally. You asked about areas of strength and potentially improvements. One of the things about our business is we have really strong pricing power in North America in the nonresidential space. Where we historically have not been as strong is in residential. And one of the things we're driving in this inflationary environment is trying to drive more discipline in pricing power in residential. So for an area of improvement, that is a focus area in '22 to drive more pricing in the residential big box space. And then with respect to my experiences, having gone out and ran, I was the business leader of our largest business, our North America Commercial Americas business, so I think 1.5 billion of our revenue. And I would say that 2-year experience has gotten me closer to the business as well as the industry. I think I have a better understanding of industry dynamics and business dynamics, competitor dynamics, which will be -- make me more effective than otherwise would have been as CFO. So I think I want to highlight the tie to the business as I enter this new role and a deep understanding of the industry.

That's great. And I also want to highlight the fact that Tom, right, we met with new IR, and then you also moved on to seeing operations roll, and now you are back in the IR role. So it's very, very unique that both of you have this deep understanding of both operations and actually how investors think. So it's very, very unique and, as I said, make it a pleasure to work with you guys. So maybe we can talk about nonresidential construction outlook. So nonresi order activity is strong. Demand is there. What are the particular areas or bright spots within nonresi specifically? What types of leading indicators are you guys watching to gauge strength in institutional end markets, which are particularly important too?

Yes. So our nonres business were strong is in that institutional vertical, K-12, higher ed, health care. And you look at those 3 verticals, I would tell you health care remains strong through the pandemic, as you would expect with COVID. K-12 and higher ed have both rebounded. So I would say this is one of those instances where all 3 institutional markets are recovering and doing well and healthy. I would say, on the health care space, that is where we're extremely strong as well as -- well, all 3 of them, frankly. And for leading indicators, we look at all the same leading indicators you all do. We look at AIA consensus forecast. We look at Dodge New Starts, Architectural Billing Index. But one of the things we're also in tune to is what's going on with our customers, our end users and our channel partners. So having a pulse with spec activity, we write specifications for door hardware and the benefit of the architect, which helps create demand for us. And so that spec activity and quote activity is a really important indicator for us. And so I would say all indicators are looking pretty good in that institutional space. In summary, commercial, demand is very strong for us in commercial. It's a question of our ability to get throughput through our plants by getting parts.

Got you. So maybe talk a little bit about resi outlook in North America. What are some structural tailwinds within the residential markets that give you confidence in the cycle over the next 5 years -- well, a few years? What are some of the key macro risks to resi? Could you talk about how your go-to-market strategy has evolved between the retail channel and homebuilder channel? You sort of alluded to sort of tweaking the pricing model, so it seems like there's a lot of stuff happening here.

Yes. So I'll start with the overall market. If you look at residential construction in North America, it was very muted from, let's say, 2009 through 2019. There was a decade where there was an undersupply of homes. That should provide future tailwind as we look forward here into the future. New starts have been strong, but closures have been less than starts as homebuilders struggle to keep up with all the demand. One of the things I know everyone is top of mind is interest rates and the impact to residential. Our belief is that current mortgage rates are still historically low versus what they were if you go back 10, 15, 20 years ago. And so we still think new construction will be okay. But if you look at our residential business, resi for us is more aftermarket, so we have a greater percentage of our business in the aftermarket, then new construction. And then on the go-to-market... strategy.

Well, and also -- right, and also, I think, distributors versus big box and pricing, yes.

Yes, sure. So half of our...

Distributors, Lennar and all.

Sure, builders. So half of our business in residential goes to big box, think of DIY. And the other half goes through distribution to homebuilders. And in the case of homebuilders, we've been pretty good at passing along price historically, not as strong as the nonres business but okay. On the retail side, we have not, we've lagged. And we are really kind of focused on driving that price realization in retail and in the residential business such that we can manage the inflationary pressures we have. That is a change, Andrew. Historically, we were kind of slow or reticent to actually raise prices. Now we're committed to raise prices in retail.

Maybe I could jump in, too. Besides all the things that Mike's talked about that gives us confidence in that market, I think we're probably a little stronger there than others and to thinking about the legs and how long that can go on or the runway. This whole secular demand of the electronics adoption provides outgrowth over a normal GDP cycle. So yes, we'll definitely go with that. But that aftermarket potential to replace existing mechanical locks with electronic solutions, smart homes, that type of an element. And our strategy there is really to be open platform. So we'll partner and play with any number of suppliers and integrators or stand-alone in terms of the solution provider. And for us, that makes that a very viable outgrowth opportunity.

And as long as I have you guys on stage, how should we think about international? Because for the audience through your own -- your brands really strong presence, I think in Southern Europe, through [indiscernible] Spain and Italy, right? You have Bricard, so France, U.K., but it's sort of -- it's very different from -- I think, from ASSA and Kaba, DORMA. It is more regional, just to give an audience a sense of what's happening, but -- and also, I think in Asia for you, it's more Korea and Australia.

Australia.

So just maybe how you think about these international markets that are, as I said, somewhat unique in terms of your exposure?

Sure. If you look at internationally outside of the U.S., they're all local markets. It's not a pan-European market or a pan-Asian market. So they're individual local markets. Our strength, as Andrew said, is in Southern Europe, but we've also improved dramatically in the dramatic regions. So think of SimonsVoss acquisition that we made in 2016. We had a legacy business called Interflex, a software business in Germany. So our international business is much stronger than when we spun out 8 years ago. When we spun out, this is a business which was breakeven from an operating margin. It's now double-digit margin coming off the best year of growth we've had internationally. Our Asian business is dominated by Australia and New Zealand, so that's the vast majority of our business there, and that's a developed Western-type economy and market there.

Got you. So maybe we can talk about sort of supply chain strategy. How flexible are Allegion's supply chains? What parts of the supply chain can you adapt to the new operating environment? And how has the supply chain strategy evolved? And what about your relationships with suppliers and dual sourcing capabilities? And as long as we talked about the supply chain here, look, we have Ukraine-Russia conflict but also sort of recent news out of Shenzhen. I think that's sort of brand new. It's like 48 hours or something like that. But maybe sort of recent disruptions, but -- and broader overview of how your supply chain strategy is evolving.

Yes. So I would start, we tend to manufacture and source in the region that we manufacture and sell. So in the case of North America, we mostly source from North American suppliers; in the case of Asia, Asian suppliers. We do source some Americas product from Asia, but it's not the predominant sourcing element. I would say that our supply chain in '21 we learned wasn't flexible enough. We ran into challenges in the back half where we were too sole-sourced. So we went through a significant effort since the middle of '21 to qualify other suppliers so that we can be more dual sourced and have more flexibility. Flexibility is the key word in our supply chain, how do we get more flexibility. Another significant effort we went through was we had a redesign our electronic lock portfolio to give more flexibility on which chip manufacturer we can use. If you follow us, you saw in our Q3 and Q4 earnings, we had some challenges in our e-lock business from the inability to get chips. So we went and they have been redesigning our e-lock portfolio so that we have multiple capabilities to use different manufacturers in our locks. So as you look to '22, we have -- as we talk about our guide as well, there is more growth in the back half, and part of that is due to this flexibility in the supply chain and the completion of these redesign efforts. So it's a combination of both. And then with respect to Russia, we don't source in that from that region. We don't have manufacturing in Russia or Ukraine, and sales there are de minimis. They're close to 0.

And is it too early to sort of ponder what -- lockdowns in China due to COVID could do to on the electronics side?

Yes. That's a couple of days. So it is pretty early for us to assess. We're keeping an eye on it like everyone else. We do source some from China. I would just highlight that we, for the most part, do source in the region we manufacture, so we may be better than others, but it is too early to put a quantification.

Mike and Tom, I think a couple of companies, and I know these are sort of more suppliers or more complex systems, but people have sort of been mentioning sort of starting to have conversations with guys in the U.S., I think. People bring up usual prospects like Texas Instruments and Intel bringing capacity because they issue the capacity sits in Southeast Asia. So you can be a region for regional you want. If you can't source electronics in North America, it's just not there. So I was just wondering, a company like Allegion, are you thinking about potential of sourcing in North -- are you having any conversations with suppliers about down-the-line sourcing in North America? Because we've been hearing other people sort of companies are asking for multiyear commitment as they put in capacity. I was just wondering how far, how broad do these conversations take place in the industry. Are you having any of these discussions? Are you talking to suppliers? Are you talking directly?

So we talk to the chip manufacturers. It's important to understand our relative size of purchase is much smaller than when you think of some of the huge players that use chips. So it's -- we're not going to be able to invest to drive chip capacity, right? For us, it's a case of how do we have multiple options out there for us, so we can use different manufacturers as well as potentially different regions.

But base as you look at the world, so just because something was -- as I said at the previous meeting, somebody said, you may start sort of sourcing, I'm sure, it's tiny amounts of stuff from North America as early in '23. So this was way earlier than I would have thought. So for Allegion, as -- once again, as you have in this conversation, is it even on the table for you guys to source anything in North America on the chip side in the next 2, 3 years?

Yes. So I would say in the near term, it's working with the people we know right. Longer term, we would love to actually get a diversification in the supply base from both Asia and North America.

This is great. I really appreciate it. So maybe we can talk about price cost. And given new inflationary environment, are there opportunities to flex your pricing strategy particularly for longer cycle projects, right? Has your outlook on price cost turning positive by second half '22 changed given the macro developments, which could likely extend out raw material inflation is just as you think this inflation thing is under control. There's more -- somebody has sort of said it's like a bad simulation.

As you look at inflationary pressures, last year, we -- at this point, people talked about transitory. We don't believe that at all. We're committed to raise price to combat inflation. So if inflation does get worse from what we assumed in our opening year guide, we're going to put in more price increases to drive that pricing to offset inflation. Our key thing is we have always had price plus productivity exceed inflation at Allegion. We did not have that in 2021. We're going to get back to doing that in '22 forward.

Got you. And maybe we can sort of talk about competitive landscape. You don't have a lot of competitors in North America. So how has the competitive dynamic between you and one of those competitors has evolved in both mechanical and electronic locks in the North American market? It seems you've underperformed just based on the public statements in the Americas throughout '21. Clearly seems it's a temporary shift due to supply chain headwinds. Do you see -- how long would it take to sort of -- because you clearly have some very material channel advantages both on, I would say, institutional and retail size, right, just shelf space, et cetera, et cetera. How long do you think it would take for you guys to sort of retake what's yours?

When you look at our '21 results, the demand was really strong. Our orders -- our incoming order rates from our customers, it was there. It was the inability to actually get the parts to ship the product, that really hurt us. We exited '21 with our largest backlog that we've had in the nonres space ever. And if you think about the core institutional markets, they tend to be very sticky, that installed base and end user standard. And as we got delayed in shipping product, I don't think that's lost revenue. What that is, is delayed revenue. So as you think about '22, we're getting much better in the commercial and our -- if you look at our guide, it's a stronger performance than you saw in '21. But we also believe as we exit '22, we're going to still have healthy backlogs for '23. So a long way of saying, I don't think it hurts us competitively long term. We're right there competitive long term. I do think this is a temporary challenge that we're dealing with due to the supply chain challenges.

I also sort of bid up on them for 5 years in a row. That's my statement. So maybe we can talk about access control, right, and thinking in the post-COVID world. What types of access control trends do you think are here to stay? And how are you guys positioned to win in this new environment?

As you think about access control, the perimeter of an institutional or commercial office building has had physical access control or software to get into buildings for quite some time. I think the big change you see in access control since COVID is that has been growing more to other vertical markets. Think about whether it's K-12 in smaller districts or multifamily has seen a big increase in access control, that increase in access control just gives us the opportunity to sell more electronic locks, which historically would have been mechanical solutions. And in the case of electronics, this is a big retrofit or aftermarket opportunity. So it's not driven by market per se but by a trend to have a more electrified opening. So that is a positive trend. Another positive trend we've seen is touchless solutions. So if you think of an actuator where instead of going up to a building and grabbing a handle, you can present your credential, wave your hand, and door will open work. So as a result, I do think there are positive trends that came in, in COVID for our industry, and it should help us as we move forward.

And maybe we can talk about sort of electronic locks, and it's also -- it's very -- always very interesting conversation particularly if you visit Sweden and then you go back to the U.S. because I think European audience tends to be quite excited about electronic locks. I know it's a big area, but U.S. just seems to be a different market. So look, can you just tell us what's the state of play right now is in the U.S. in electronic locks? And maybe you can also tell us where it's Southern Europe in electronic locks. And obviously, you have presence in the Korean market. So that's maybe a good compare and contrast. But Asia is sort of state of play, right, because I think these are some of the global extremes as we talk about in your presence in all of them. But maybe we can talk about the evolution because I think when people talk electronic lock trends, North America is a big focus. Clearly, you guys have very, very healthy business. So I know it's a lengthy question, but maybe you can bring it together for us.

I'd say let's start with residential in North America. The first residential electronic lock is probably 12, 13 years old. That's it. We're now -- we were the first residential electronic lock. And then a few years ago, we introduced the first residential WiFi lock, right, connected WiFi lock. The front door is in its early stages, early innings of being electrified. And this is a trend that will continue to give us, as Tom said, tailwinds to our growth moving forward. So potentially, maybe 10% of all homes has an electronic lock or less. And so this is something where you could see growth for the foreseeable future driven by the electrification of the home and the connected home driving e-lock sales for us. Nonresidential, perimeter, like, I mentioned earlier, has been electrified for a while for certain vertical markets. We're seeing more vertical markets become electrified as well as the interior has been very slow to adopt for electronic locks, right? We have seen acceleration in multifamily, where historically you would have a key if you moved into an apartment. Now you could potentially have a credential. And so that would be electrification of the entire building. If you -- so in the case of, I would say, nonres, middle innings to late innings on the perimeter, but in the interior, infancy, very infancy. And then as you move out to Europe, we operate in certain markets. So in the case of our Germany business, SimonsVoss, that is a great opportunity for us to drive electronics. So it's an electronic cylinder company. In Australia and New Zealand, when you move to Australia, much more mechanical than even the U.S. So everyone is at a different stage of maturity.

And so maybe bringing access control electronic lock, another question we have, does this create an opportunity for disruption because there are some sort of new companies popping up, so there is a thesis that somehow the mechanical product becomes more commoditized. And it's really the software becomes sort of the key driver of value. What have you seen? How do you respond? How do you sort of look at the world 5 years from now?

Yes. If you think about nonresidential, one of the things that I think might be underappreciated is just how complex the 2 largest players their product offering is. The complexity of codes and standards in North America and the products that you must offer really provides us a competitive advantage. And as the lock becomes electrified, these new entrants just can't have the proliferation of offering that the incumbents do. So I think that the incumbents have an advantage in the electrification of the product that new entrants don't have. And so I do see that as a benefit to the big incumbents. In the case of residential, it's the scale benefits that the big players have that other small start-ups would struggle with. If you think of the magnitude of locks that we put through our Baja region, our manufacturing capability and facilities down there, that is something that we think is challenging to duplicate. So in general, I do think the large incumbents will really benefit from this transformation to the electronic from the mechanical offering.

Got you. Just so you think for more complex commercial projects, even like multifamily res, and as you move in, is just the spec -- it's just the moat created by the complexity of U.S. regulatory environment, it's -- yes, no, because look, I mean the example I was tell people we put brown doorknobs in my apartment, which apparently are not -- it was a restoration. So -- but apparently, America's disability access, that interpretation in New York City says you can't have that. You can have that in New Jersey, you can have it in Westchester, but in New York City, having a round door knob, you're not supposed to have it.

Right. So that shows the complexity of this industry.

You're right. And you can get around door knob in New York City but just you're not supposed to. But we did get it certified, so it's all legal. Don't you worry about it, we're not breaking any laws here. So maybe we can talk about international strategy. Now that International segment has been and it's consolidated for them for over a year, how have you seen strategic growth priorities evolve. The business margins have improved under the new structure, actually, quite a bit faster than I would have expected. Are there more opportunities for restructuring to drive continued margin expansion? And what is the longer-term operating leverage or margin expansion target? And I am very well aware we're manufacturing footprint is, and I'm very well aware of what the capacity utilization there, yet you have been able to make very material progress.

Yes. So as I mentioned, when we started out breakeven business internationally, driving it to double digits. Now for those who have followed us for a long time, we've had this aspirational goal of double-digit margins for years, while in 2021, we exceeded that goal. We also in '21, for the first time, Andrew, we really focused and drove significant growth in international. We had our best year internationally growing. As we move forward, I don't think this is a restructure cost-out/cut. I think this is a case of driving margin expansion from growth. And when you look at us, I think the important thing, we've been talking about operating margins, but on that EBITDA margin, they're in line with competitors, which is the first time we've really been able to say that vis-a-vis our competitor base. So I think we've done a really good job in expanding margins, and where we go from here is leveraging that growth to drive further margin expansion.

Got you. And maybe we can talk about sort of restructuring and productivity. I mean, clearly, what I'm picking up sort of pricing, different strategy on pricing in the channel, that's clearly something brand new. But are there any other sort of self-help levers that Allegion can pull in the current operating environment, further cost takeout opportunities, increasing productivity through investment in automation? What's available to you in your toolbox?

As you look at 2021, I think we were more inefficient from the supply chain challenges than we ever have been historically. As that gets improved, I think you're going to see naturally see more productivity in our manufacturing capabilities and plants. You mentioned automation. Automation is key for any manufacturer. It's tough to get labor, right? So if you can use capital and automation to help replace the dependency on labor, the better you'll be operationally for the long term. So I think it's a combination of both. As we improve our supply chain and operational capability, the productivity will improve as well as driving automation to help improve our throughput and profitability.

And in terms of the automation investment without quantifying -- well, maybe you can't quantify it, but how should we think about based on -- so is it fair to say that you -- we've done some work. This sort of shows a 2-year lag between labor cost, and it takes 2 years to actually put in the automation project. So would you sort of thinking about it an internal planning process follow that logic? Or any -- I think we were in the Honeywell Analyst Day. They sort of talked about they doubled the automation spending. This year, they're going to double it again. Just any sort of framework how to think about automation investment at Allegion.

Yes. So if you look at our CapEx, we started to pick it up a little when we gave our guide in the current year. I would say this, as you think about manufacturers, the investments you make in your plants are -- they have short paybacks and they're good returns. So if you can use automation to drive efficiencies in your plants, we all should do it. And so it's something we have picked up in if you look at our Princeton facility. It's probably our leading facility from using robotics and cobots in driving automation. And I would expect all of our plants to get better over time in utilizing automation.

Got you. So maybe backlog quality, if you were to give a snapshot of Allegion's backlog as of right now, how would you break it down more weighted to resi and non-resi, retrofit versus new construction? And it's always a question I think that sort of went away a little bit. But how do you think about double ordering? And what happens sort of once lead time get extended and once you sort of raise prices enough?

Yes. So backlogs are at historic levels for us especially in nonresidential. Nonresidential is a made-to-order business that now has extended lead times. So what's happening, and we see this, customers are placing orders sooner. If you know you have a project that you need in June, you're not going to wait until May to place the order. You're going to place the order now. And so there is some advanced ordering that's coming from the channel and customer base. We haven't seen a significant cancellation per se. You place that order for a specific project application or opening, you're going to see it through. I will say the orders are coming a little sooner, so -- which gives us visibility for '22 as we look at the year why we feel so confident about demand for 2022.

Got you. That's very good. So maybe we can sort of shift to infrastructure stimulus. The federal government passed 550 billion of stimulus for the infrastructure. And there was COVID stimulus mainly approved for educational CapEx. Everybody was sort of super excited about it, I think, last summer, at the end of last summer. But have you started to see any benefit from the stimulus? I would imagine, if you think about the educational markets and if you think about sort of summer retrofits, we should start seeing some of it. Or is it now getting pushed out into 2023?

Stimulus can only help. If you look at our business, high proportion to higher end in K-12, I think the stimulus money was you throw staggering numbers out there of 550 billion, the locking industry will be a very small piece of it, but it will be a tailwind for everyone in the space. As far as like quantification, it's super challenging to try to quantify how much that will provide. I would say this though, I do think that it can only help provide further tailwinds to our growth as we move forward.

Got you. Maybe sort of expanded sort of topic and now that you're CFO, have the purse strings, capital allocation, what are the capital allocation priorities for Allegion over the medium term? And how should we think about sort of strategic acquisitions because I think for a while, we sort of -- we're talking about stuff getting done and Kaba, DORMA happen, things I think have quieted down a little bit, but then there's a lot of emerging technology out there. So first, a, how do you think about your capital allocation priorities? And then maybe we can sort of dive into what's happening out there in the market and what's out there and what can Allegion do strategically.

Great. Our capital allocation policy has not changed. We talk about having a flexible and balanced capital allocation policy where we prioritize M&A, but if M&A is not there, we're going to return excess cash to shareholders. With respect to M&A in particular, I would tell you the key thing is finding the right strategic assets and look for us as we look to do M&A to focus on acquisitions to help us drive our seamless access strategy. I've been talking about electronics growth for a lot of this fireside chat, but this is anything that helps us get better in driving that seamless access strategy, whether that's connectivity, software or electronic products.

And -- but in terms of M&A, is there a regional priority for you? Is there a product priority? Is it hardware versus software? What's exciting, what's available?

Yes. I would say this, look, all 3 regions are our priority for us, and we want to grow in both international and in North America. As far as particular M&A, I would say anything to help drive electronics would be a priority. So that would be the primary focus. If a great mechanical company became available, certainly, we'd be interested as well. You have seen -- if you look at our North American market, a lot of the mechanical consolidation has already occurred historically. But as we drive our seamless access strategy, that would be the top priority.

So should we assume that I think for a while, we sort of booked the doors? Is that sort of we're down with doors for now?

We did expand our hollow metal capability to get better and improve. I wouldn't put hollow metal doors as our priority. Anything that helps us drive electronics going to be more of an improvement. Hollow metal is -- what we have, I think, is sufficient to run this business.

It does make a lot of sense. And maybe last question for me. We talked a lot about sort of architectural hardware, maybe electronics hardware, but I know you guys also have pretty neat software capabilities as well. Can you just describe what you have, what drives it and where do you see your software capabilities in 3 to 5 years?

It's an area of focus for us. So 5 years ago, in 2018, we made an acquisition of a company called ISONAS, which gives us access control software capabilities, look for us to expand that software capability in markets where we don't partner, so that would be certain multifamily, SMB, et cetera. So software capabilities that help complement the partner strategy we have with [ Pax ]Partners. As well as we made an acquisition of a company called Yonomi that helps us build our IoT platform which makes our locks easier to connect with other parties in the ecosystem. So that's something that makes us better and easier to work with. So both of those software capabilities is something that we've improved versus where we were, let's say, 4 years ago.

That was great. I think we're generally out of time. Mike, Tom, always a pleasure to have you guys. Thanks so much.

Thank you, Andrew.

Yes.