Allegion plc (ALLE) Earnings Call Transcript & Summary

All right. Good afternoon, everyone. We're going to keep the presentations going with Allegion and very happy to have Mike Wagnes with us, the CFO of Allegion. So thank you very much for joining us.

Thanks for having us.

Looking forward to the Q&A, and we're just going to jump right into that. [Operator Instructions]. So Mike, I think it would help to just start with, I mean, obviously, dynamic environment over the course of the past 4 months when you think about a lot of the moving pieces, so could you provide kind of a general overview if you think about major verticals in terms of kind of sentiment shifts, demand pattern shifts. I mean, as we're all nervous I think, about the ratcheting higher of uncertainty kind of how you've seen that materialize in the course of like the day-to-day for you?

Sure. So if you know Allegion, we have our international segment as well as our Americas. And within the Americas, we have a nonres piece and a residential. Nonres being the largest part of our portfolio, demand patterns are really strong. We struggled in 2020 in the pandemic in nonres into 2021. Demand started to pick up midway through the year. And then accelerated in Q1. So we had a strong Q1 from a demand. We had double-digit growth in our nonresidential business. And the demand patterns were even stronger than that. If you look at where we're strongest, we're strongest in institutional vertical markets, think K through 12, higher ed, health care, all 3 of those have been very strong for us. And from a demand patterns, they tend to be very late cycle business. So nonres tends to be late cycle. Institutional is the latest of the late cycle. And then door hardware tends to be one of the last things that gets put on the building. So we just started to pick up some steam in '21, and we're accelerating in the first quarter. So overall, demand there is strong. If you go to residential, residential is stable for us. We're more of an aftermarket play in resi in North America. And then even the new build, we believe this is not 2008, 2009 residential where housing starts just stopped. We think it's a stable market environment. And then lastly, international, our international story has been a self-help story. So we -- when we spun out from Ingersoll Rand back in 2014, this was a business which was low growth, 0% operating margin. Where we are today, we're double-digit margins. We had a very good Q1 growth for us. We tend to be in Europe, in Western and Southern Europe, so not in Eastern Europe. In our international Asian presence, our Asian presence is Australia and New Zealand. So that Western economy. So international for us is a case of us performing and executing as well as market dynamics. But we've done a better job of executing there in the international space.

And maybe just on that last part, when we think about kind of the fluidity of what's happening in Europe, I would say, probably most helpful in terms of what you saw in April. But any evidence to you in terms of demand patterns there, probably primarily concentrated in I think about Western Europe, but what you're seeing, whether the uneasiness is creating any hesitation on projects moving forward?

Sure. I mean, certainly, all companies are impacted by the current dynamics there. When you think of our presence in that Western or Southern European as well as being late cycle. We have not seen dramatic declines in demand. Demand there, what we saw in Q1 was actually pretty good. We're going to keep our ear to the ground. Obviously, this is major macro events that we're cognizant of. But so far, that has not impacted us the dynamics there in Europe.

And then maybe in terms of running your organization, right, is just your kind of reading headlines. I mean what are you doing internally? Is there more kind of scenario planning so that you have kind of pieces in place for these outcomes we're going to do this? And just how do you do that internally?

Sure. I mean if you think about the last 24 months, it's been a challenging macro environment. It started with the pandemic that came out of nowhere. 12 months later, you're dealing with supply chain challenges that you've never dealt with before or at least have in my professional career inflation that is at levels that we haven't experienced in quite some time. So I think you have to be adaptable and flexible as you think about how we -- as we operate. And if you consider our business, what we're going to do is we're going to run it for the long term and make the right long-term decisions for our business. We're an asset-light company. So when we think about how we deploy CapEx, if it's the right decisions, we deploy it, we're not building many new big plants. We're able to meet our demand with our existing plants that we have today. So it's a case of just being flexible and cognizant of external market indicators and being able to be able to move and change as things -- as dynamics change. A great example would be if we started off 2020, one of the best first quarters through the month of February, we have ever had. And then all of a sudden halfway through March, you have to have a completely different mindset as you're dealing with a pandemic that you've never experienced. So I think these examples in the last few years kind of give us some experience on how we just have to be a little flexible in our mindset.

And then you talked about kind of asset light, but when you think about kind of the CapEx budget, I mean, is there anything that was planned for the year that you're starting to say we're going to push this out a little bit, kind of maybe reevaluate back half of the year, I think about 23% instead.

Yes, I would say we never want to be shortsighted and make bad business decisions. So if we can spend money on CapEx to increase flexibility in the supply chain, we're going to do that. It's the right thing for us to do. There's no major initiatives out there that we would want to delay if it's the right thing. So as you think about our CapEx, we've always said 2%, 2.5% of revenue in CapEx. I think that estimate still holds today for our business.

Okay. And then I wanted to think about kind of through cycle growth. And if you think about, I think what Allegion been able to achieve over time, you look at the 2014 to 2019 period of time, 5.5% organic growth on average, I think roughly kind of 4 points of volume, 1.5 points of price. Is that the right growth algorithm? Is there anything that you see kind of shifting the changes that at all?

Yes. If you look at our business in our industry, one of the key dynamics about our industry is, it's going through a migration from purely mechanical to electromechanical product. And that's something we've -- this industry has had underway for 5, 10 years now. And what that enables is it enables above-market growth for market participants and market leaders like Allegion. And so what you saw in the last cycle is we have above-market growth from the tailwinds of this electromechanical conversion. As we move forward, we expect that to continue over the cycle. This is not an industry where like the foot phone becomes the smartphone, and we all have a smartphone within 4 years. This is just a steady tailwind to our growth patterns moving forward where we can have above-market growth. So that algorithm you lay out there the mid-single-digit plus growth because you're getting some price and good volume. I think that over a cycle absolutely still remains.

And what about -- I mean, if we think about the ceiling maybe on the electronic lock kind of growth and penetration, where I think it's roughly 1/3 on the resi side now and probably more like a sixth on the nonres side. But when we think out a decade, I mean where do you think about that going?

It's all about really the installed base and what percent of that is electrified, not even just our revenue numbers. So in the case of your neighborhood, walk around your neighborhood, you see how many mechanical locks are still on the front doors, right? It's a big opportunity that is -- that will be converted over time. If you take my children, they've never had a keep when they get older, they're going to have an electronic lock, right? They've only experienced electronic locks in their life. In case of nonres, if you think of certain vertical markets like higher ed Higher Ed is going to transform from a mechanical solution to a fully electronic solution over time using your cellphone as the credential, not even just your badge anymore, but your cellphone. Those dynamics are long-term trends that would bode well for Allegion. And we feel that we're in certain elements, earlier innings, right? So if you think about higher ed, the vast majority of campuses today, those door rooms are all keys, right? Over time, they're going to become electrified locks. In the case of residential homes, like I mentioned, you'll see that as well. So we do think there's a lot of runway in the electromechanical convergence.

And I think there's some debate with a technology shift potentially opening the door to new competition, right? And so your evaluation that talk a little bit about partnerships you have or technological capabilities you have. I mean, how is there a moat for you in that space?

That's a great question. We've seen some new technology partners coming into the space, especially something like multifamily. And the key thing to understand about the nonres space is the importance of the breadth of the offering. So some of the new entrants may make a resonant unit lock. That seems glitch. But when you think about a building, you need to have the electrified exits, the electrified readers on the perimeter. You need to get auto operators, which are electrified all these products that we have in our offering that these new entrants literally make. And so our strategy as we think about seamless access and taking advantage of this. The current dynamic is -- in the case of complex verticals like a hospital, a university and even a K through 12 school, we're going to partner with software companies on the access control side, and we're going to be the hardware provider of both mechanical and electromechanical. In the case of multifamily, we could do both. We could do the partner strategy, and we can have our access control software that works with our products. It's this flexibility that we think we're positioned well. And if you think about the new entrants, they're more targeted in select vertical markets, but across the broad swath of the nonres space, there's only 2 players in North America that really fit the suite of offerings needed in those complex verticals.

And then I wanted to pivot to inflation and sort of talk about the magnitude of inflation that you've seen, inclusive of if you could talk about just year-to-date what you've been seeing out there?

Yes. So if you look at our 10Q, we put some disclosure on what's our price versus our inflation. And what you saw in Q1 is pricing has been as strong as we've ever had, right? So we had 6 points of price, and we were still slightly underwater from that price cost dynamic, much improved from how we finished Q4. Q4 was more underwater than what we saw Q1. As we look throughout the year, we've already put in the pricing actions. These are announced accepted pricing actions that will give us tailwinds throughout the rest of the year. So we should get back to, in the case of the Americas, were back to that breakeven number in Q2 and then positive Q3 and Q4. So from a pricing standpoint, we've been emphasizing the importance of passing along inflation to our customer base. And we felt in Q4, we were a little late. We've done a better job in Q1 and feel we're positioned nicely for the rest of 2022 to recover that inflationary pressures.

Have you developed any new internal processes in terms of evaluating what's going on in the inflationary environment to act more quickly on the pricing side, just as a kind of [indiscernible]. .

Yes, absolutely. We have to be quicker, more dynamic in getting in price increases. So in certain of our businesses we've announced price multiple price increases throughout the year. Historically, in the nonres space, we would come with 1 price increase early in the year, and that's our price increase for the year. Last year, we took multiple price increases we put in another price increase in the beginning of this year, and we've also announced in the summertime, late June, another non-risk price increases. So that's poor in the span of 14 months. Historically, we would have 1 in that period of time. We've also taken actions in our residential business. So our retail business, historically, we have not been as aggressive in flexing that pricing muscle. We have started taking those actions this year announced in the second quarter. So those, again, are pricing actions in the marketplace today that we can capitalize on.

And as you sit here today and think across the major cost buckets and sort of looking forward, do you anticipate a continued inflation in some of these buckets? Is there anything where you're seeing signs of or anticipate things kind of easing a little bit?

If you looked at our Q1 guide, we increased our price as well as our inflation guide so that they offset I think that's important to understand that we're going to be prepared for more inflation, and we're going to pass along that price. We've seen inflation across the supply base, whether it's metals, labor, freight, we're prepared to live in an inflationary environment and pass along that price. If there are commodity deflation, I think the key thing about our business is these list price increases are now part of the new price list of customers and they're sticky. So if there's commodity deflation, we don't have to give it back. It stays within that price book. So I think we're positioned well if there is deflation, but we're prepared to live in an inflationary environment.

And just given the uniqueness of this inflationary phase, my impression is, historically, this is not a give price back kind of model. But when you think about kind of the competitive environment and the magnitude of inflation and if we were to see kind of a decent correction from that, would you anticipate that there's -- whether it's a competitive reaction or whether it's the customer kind of just putting up his hand saying has to come down mean is this time going to be different in that price [indiscernible]?

It remains to be seen. I would say we're always listening to our customers and watching what our competitors are doing, like any business in any industry. What you will find, and this is an important dynamic, especially in the nonres space. We compete on value, we don't compete on price. We drive demand by writing specifications and working with end users and architects. And so as we think about this environment, I don't know what the future holds with respect to massive deflationary environment coming, but I would just say look for us to continue to drive price realization and manage those inflationary pressures.

And then I wanted to move on to supply. And when you think about some of the countermeasures or mitigating actions that you've taken when you think about redesign, dual supply. What inning are you in, in terms of the reaction to some of the supply challenges?

Yes. So last year, we got hit hard by supply chain challenges. And we started undertaking a process in the summertime of finding alternative supply, whether for qualifying mechanical suppliers or getting alternative chip suppliers. And I think the big learning over the last year is you're never done. We are going to build flexibility in the supply chain to be able to manage the challenges that we're currently seeing. So we've completed the first wave of some of the redesigned efforts that we undertook last year, but we're working on the other suppliers to make sure we have redundancy in the supply base. So from a standpoint of getting supply, which is really the most important variable for us, we have seen improvement on the mechanical side, and you saw that in our Q1, growth numbers for nonres, we grew double digits. There's still a global challenges in semiconductors and chips and that's something that we're all going to in North America deal with for some time or even the world. But it's -- for us, it's about building that flexibility so that we have more than 1 supply for the parts so that we can be as nimble as we possibly can be.

And so related to that, I mean, where are you in terms of building out that supply base on the chip side? And then how are you thinking about the timing of when the crop situation gets better?

Yes. For us, it's -- we built flexibility now you're on line to get it from all the semiconductor suppliers that you work with. I would say we've done good activity to get that flexibility. The challenge for us has been the ability to get the amount of -- to meet all the demand that we've seen. Our demand has spiked in our electronics business. If you look at our nonresi -- I'm sorry, our Americas electronics number, we were flat in Q1. We couldn't keep up with all demand. Demand was significantly higher than that. So it is something we're managing through. It's -- but it's going to impact us all of '22 and into '23 and maybe even longer. The key element here is we're going to build that flexibility to try to be as nimble as we can be on the electronics side.

Got it. And then just China in general, I mean the degree to which you're feeling kind of any pressure there related to supply chain impacts?

Like any multinational, we have suppliers from China, and our supply base has a reach into China. We are -- we tend to source from region where we manufacture, but we do have that impact from China and the global supply base integrated supply chain. I would say if you think about our business, the longer this last the more of an impact it would have. As we think about 2022, we don't believe, based on where we are today, that it would affect the full year revenue, but if this lasts significantly longer, there could be impacts to any business related to a shutdown of China.

And then what about on the labor side, I think the PMI out earlier this week, a pretty consistent theme across end markets, talking about sounded like incremental labor constraints. What you're seeing in your business, the amount of turnover are things getting worse or things getting better?

Yes. We've experienced significant labor constraints, and it went back as far as early of 2020 in our plants and even our supply base, our domestic U.S. supply base. We've taken actions to try to increase labor by raising wages, and we've seen some improvement in what we have in our plant. But manufacturing is definitely tighter from a supply of labor than it was 3 years ago pre-pandemic. So -- this is -- the labor constraints are something we're going to have to deal with and manage through. It is still a tight labor supply.

And then I wanted to shift to Americas and start on the margin side of things. And if we go kind of pre-pandemic, a segment that was doing very high 20% kind of margins, what -- is it -- is there something structural within that makes a return to that type of margin level unrealistic or walk us through the path to kind of getting back to those types of margins on the legacy business?

Yes. So there's -- if you think about our business in the Americas, high variable contribution margin as we get volume, we should be able to leverage volume and grow margins. We have strong pricing power. So there's a lot of positive dynamics that make me believe that there's no reason why structurally this business is any different. I think the key variables are when does inflation subside. And then obviously, portfolio as well, we've announced a big acquisition, which has a lower margin profile, which obviously the mathematics of that would bring the segment down. But the core business that we have today, we believe that we can get back to growing those margins this year and will continue to grow next year and onward.

And to get back to kind of prior margin levels, do you need deflation for that? Or is this -- over time, you continue to navigate in that direction?

To me, it's a question of when and how fast you get back to those levels with that high variable contribution margin, we should be able to leverage volume and improve margin. If there's deflation, we'll get there even faster because the pricing is so sticky in our industry. So if there is deflation, I think it certainly happens faster. But I think structurally, there's no difference in our business model that says we can't continue expanding margins.

By what year would you be disappointed if you're not back at those kind of margin levels?

I'd rather not throw a year out there and rather just say, we're going to continue to expand the margins, and it's all dependent on inflation. Where we sit today, we talked about the Americas 2024 in the February earnings call. With inflation that started the year, we still think that, that would have been realistic if inflation still continues to accelerate. It could get pushed out a little, but this is not a massive change to that guide that we gave you before. So that analysis of 2024 is all dependent on what is the inflation in the marketplace.

Great. And then I wanted to talk about Access Tech, which seems like a really nice kind of product line addition to the portfolio. But to your point earlier, this is a lower margin business. So talk a little bit structurally about that. Is this a business that ever gets to the Americas type margins? Or what it is about the business that means it's a different margin profile?

Yes. If you look at this business, it's different than our core hardware business. And so the industry, where it be us with this new business or [ OsaDK ], which both own a business in this space. No one in the industry has commercial hardware margins in this particular auto door business. The North American commercial hardware margins are the highest of any market participant. What I mean by that is all the players in this space make their highest margin profile in the North American segment. And this particular product offering does have a larger -- has a lower margin profile than that hardware business. So it is a market dynamic. This is not going to be -- you mentioned the 29%. That is not where this business or this industry historically has been.

And is it a similar kind of growth algorithm?

Yes. I would say from a growth, we talked about this some on our acquisition, Paul. This is a business that grew historically, the mid-singles we threw mid-single digits. We threw out the 2022 number for some perspective of the high single digits. So it's a good growth industry for all the players and we're really looking forward to adding it to our portfolio.

And then I wanted to come back to the North America markets and start on kind of the nonres side of things. I think the well-followed macro data continues to kind of point in a positive direction when you're talking ABI or Dodge. But if you talk about kind of what you see internal indicators, kind of what you're seeing in terms of specing activity, the folks that you're talking to out there, just sort of general tone in the nonres market in North America?

Very strong. right? Nonres markets, like I mentioned earlier, starting to accelerate in the middle of '21 remains strong, and Q1 was the term we had in our earnings release was robust demand. ABI indicators are good. The AIA consensus is strong, starts are good, spec activity really strong, and order activity has been very strong. So distributor partners as well would have the same sentiment. So we feel the market is very solid and robust in the non-risk base.

I think the most recent ABI print referenced this. I'm curious if you've seen any indications of it. But whether rates going up, the prospect of continuing to move higher, has pulled in any activity?

If you look about how that would impact us since we're so late cycle in the construction phase, right, hang in door hardware is one of the last thing that happens before the [ fire marshal ] gives to CEO. That wouldn't impact us for some time. I mean, it could very well be some people have some projects that were on the sidelines that they're looking to get in and to commit the financing prior to rate hikes. But in general, I would say, overall strong market demand.

And then I think we're all kind of familiar with thinking about ABI or -- do might give you 9 to 12 months. But I mean how good do you feel about the visibility that you have in the business today? How far out do you feel like you can really see?

That spec data is pretty good because you write the specification before you even break ground. So strong spec data gives us comfort that you have a good market to work with for 12, 24 months, right? So as you think about this construction cycle, our internal earliest data would be that spec data. And so as we see strong activity, especially in institutional verticals, that makes us feel strong about that market for a couple of years.

And then when you think about kind of the supply challenges over the last 12 months, I think on the spec side of things, it doesn't sound like that's been disruptive to kind of your share of the market, right? But on the kind of same day type of buy, does that kind of create any share shifts in the market? Or do you think when you have the supply, people come back?

Yes, I think long term, I love the way our CEO said it at the February call. If you need product today and Allegion doesn't have it, you're going to find it, right? At the same time, these institutional end users who are loyal to Allegion and have a suite of Allegion products throughout their campus or their hospital. There is an installed base there that helps you when you have supply challenges. If you're a university and you want to retrofit your campus to an e-lock solution, you're going to wait to get the e-lock solution that's already in half your dorms rather than try to bring someone else onto your campus. So in that institutional space, we feel really good about our ability to maintain you temporarily could lose some of that discretionary at the same time. That will, over time, hopefully come back as we get the supply chain in order.

And then let's shift to the resi side and the cycle there? And maybe kind of walk us through what you saw kind of pandemic influence, how strong things got, maybe how much they've settled from there kind of views on the stability of where we are?

Yes. Our residential business in the second quarter of 2020, our plants were shut down, which made the majority of our residential product by the Mexican government due to COVID. So at the same point, the market is at an inflection point of increasing demand, we were shut down. So starting in Q3 of '20, all the way through the summer of '21 through Q2 of '21, we've been playing catch up there. So we had some really strong comparables in that 12-month period. So if you look at Q1 of our current year, you saw negative growth in res. At the same time, if you look at a 2-year stock to a normalized Q1 of '20 pre-pandemic, that was a mid-teens growth. So the 2-year stack was strong. It was just we were comping up against the impacts of both a robust residential businesses market as well as the plant shutdown impacts.

And when you think about that mid-teens versus pre-pandemic, as you look at that, do you think more like -- we've got to be prepared for that to soften a little bit because it's still be inflated relative to normal demand trajectory trends or in terms of your evaluation of what's going on in kind of the resi marketing cycle, how are you thinking about that demand stability?

Sure. The term we're using is stable for res. If you think about nonres, we feel that is a stronger market. We'll accelerate in the back half of this year in our residential business from a growth perspective as we go against some of those easier comps. And then as we move forward, think of it as stable growth. This is not double-digit growth, but solid, stable growth.

And then I wanted to touch on resi pricing. I think this was an area of opportunity for you. And so maybe kind of take us back to what needed to change. What has changed where you are in that process?

We have a legacy in our business of really flexing the pricing muscles in nonres. In residential, we have not been as disciplined historically. And so in the current inflationary environment, we had to get that discipline. And we were a little late in residential in doing it. We've announced the actions. In the retail channel, the last of the residential channels to get the pricing actions. That's in effect in the second quarter. So it's a case of flexing a muscle that we haven't historically used. And the important thing for us is making sure we stay ahead of this inflation moving forward, that as there is more inflation passing along that price as needed.

And it doesn't sound like it, but I mean, have you seen any elasticity of demand into that market as we're working for more price?

We haven't seen any impacts on that yet. Now the competition is also taking similar activities as well.

I think that brings us to the end of our time. So thank you very much. Thoroughly enjoyed it.

Thank you.