Allegion plc (ALLE) Earnings Call Transcript & Summary

Thank you for joining us. The next presentation is Allegion, and joining us on stage will be John Stone, company's new President and CEO; and also Mike Wagnes, the company's CFO. I think John is going to start with a couple of slides, and then we're going to go into a fireside chat format. And as I said, folks in the audience, feel free to interrupt and ask questions. The idea is to make it interactive. Thanks so much. And John, welcome to London.

Thanks very much, Andrew, and good morning, everyone. Very quickly, we're not big PowerPoint people. We work in security and access solutions, so we'll make this rather quick and just give a brief overview of the company and then join the Q&A. So who we are, Allegion, leading provider of security and access solutions. You could define us also as a pure play in that space. Strong brands, as you'll see. We are a house of brands coming out of a carve-out from Ingersoll Rand in 2013. Many of these brands having leading market positions where they compete. Within our industry, I'd say by a fair bit, leading organic growth and leading EBITDA margins. Quite broad customer base. And I would tell you, we have a strategic pillar within Allegion that we want to be and expect to be the partner of choice when it comes to various technology providers in our space. So think of Apple, Google, Amazon that makes smart home systems. We are a trusted partner with them, a leading partner with them. And so those partnerships, those open ecosystem is quite important to participate in. We are a company of experts, expertise in the Internet of Things, expertise in electrification, which is one of the secular growth trends in our space, as well as cybersecurity, both in the product itself as well as our enterprise. We have a healthy and growing services business. You'll see this noted in our 10-K. We have an engaged workforce. We pride ourselves on having the safest workforce in our industry. We have manufacturing operations throughout the world and keep our employees safe as a matter of culture and responsibility. Strong fundamentals in what I would categorize as a disciplined industry. We'll talk more about that, I'm sure, in the Q&A. And then certainly, after last year, completing the largest acquisition in our history, the $900 million purchase of Access Technologies from Stanley Black & Decker. While we have been near-term focused on delevering, like we told you we would, a lot of that is done. There's a little bit left to go. As we generate excess cash, we certainly expect to deploy that cash towards growth, and we'll talk about that more. House of brands. As I said, these brands very much united our people, very much united by our vision of seamless access in a safer world. That mission, all around safety and security, is what drew me to Allegion from about a 20-year career with John Deere. Loving being here with this company. I really appreciate the mission. It feels good to work in this space. We talk about the future when we talk about capital deployment. Best way to predict the future is to shape it yourselves. So when we look at what are we doing to drive organic growth, where our 60% to 70% of our engineering hours going right now, it's to mechanical, electrical, software engineering designs. Again, this key secular growth trend is the transformation and adoption of electrification in our hardware. That has been a growth driver for a few years, and we feel it has many years of runway left in front of it. We also have ventures and partnerships. I think this is where Allegion stands out. Once again, we have quite a distinct advantage when it comes to new and potentially disruptive technologies in our space. We have Allegion Ventures. It's a captive venture portfolio. Just celebrated its fifth birthday and continues to make investments in early-stage startups who are doing new and interesting things with regards to technology that's relevant to our customers and relevant to our hardware. Lastly, on the buy side, we do expect to be, and you can expect us to continue to be acquisitive. We're building dry powder, generating excess cash to be able to acquire both bolt-on hardware assets at attractive valuations that generate a good ROIC for our business as well as also looking forward into new technologies that will -- so when we think about growing in software and services through acquisition, think of it as acquisitions that will expand our total addressable market. We'll build more recurring revenues, but still leverage our demand generation and specification writing expertise and leverage the existing distribution channel and distribution partnerships that Allegion has built up over the years. Quick point here on, again, what is right now and will continue to be in the near term, the key secular growth drivers, that is electronics and electronics adoption in access and in security. So all the way back to 103 years ago, Walter Schlage himself, certain name for the lock brand, patented a smart home first with a door that as you open the door would turn on the lights of the home. So kind of an interesting smart home innovation a century ago, to in the '70s, revolutionizing access control with ProxCards keyless technologies to now what's still driving the electronics adoption in our industry is digital identity, mobile credentials. This is driving 2 things for the end user, and while they're continuing to adopt electronic hardware is the digital ID mobile credentials. Of course, more convenient. Smartphones are ubiquitous now. They also bring with them added layers of security, so it's a more convenient experience. It's a more efficient experience for the end user, and then also added levels of security. So that will continue to drive electronics growth for us for the foreseeable future. That's it for the presentation. Tried to keep it brief. Andrew, let's get to the fireside.

Yes. No, that's great. So John, maybe -- guys, thank you very much for -- Mike, thank you for being here. So John, you have been at Allegion for a bit more than 6 months, and I will tell the audience that I used to cover John Deere in my prior life. And John came incredibly well recommended. I just -- that was the feedback. So I will say that.

Thank you.

What was the biggest opportunity and the biggest sort of challenges that you see for the company over the next 12 months and down -- maybe 3, 5 years down the road? And also what has been the biggest surprise for you so far?

Okay. Biggest opportunities, I would say, is, again, I'm blessed with a company full of experts. I'm blessed with an incredibly durable business model where we have, I would say, the largest specification writing team in the Americas, which is our core business. And as a former machinery guy, seeing that you can, as a trusted consultant, as a trusted adviser, trusted expert, work early on in the design phase with an architect to specify your products into this building, use that as your demand generation to pull product through a channel, is incredible and incredibly durable and robust versus pushing product through a distribution channel. So with that to help you keep your prices sticky, to help Allegion's operating system that's been very disciplined on maintaining margins, we've got this raw material to now add on to it a growth-oriented mindset within the company. And I think that's what I am bringing. The key opportunities we have is to really double down on this electronics transformation that's happening with our end users. We talked about some of the demand drivers. It's more convenient. There's added security. It leverages things like your smartphone to manage your credentials and things. This is the near-term double-digit growth driver for Allegion. We need to double down on that. But there is also, on the heels of that and almost parallel with that, growth in software and services that I think you can look for Allegion to invest in organically as well as through acquisition, to continue to generate above-market organic growth and do so in a way that is accretive to our margins, which, at the margin level we have today, you can imagine in the hardware space, that's not easy. We have the opportunity to do that. Challenges, I think, obvious, as I joined, Allegion was in the midst of some really difficult supply chain issues and availability issues, particularly on electronic components. Most of that is behind us. I would say on the mechanical side of our business, to use -- we're back to the kind of lead times that a book and ship, a make-to-order business is used to, so 2- to 4-week lead time on the mechanical products, which also means our channel does not hold a lot of inventory. It's build to order, and our factories are performing well in that regard. The electronic supply, not perfect yet. Demand is still extremely strong, so do everything we can to meet that demand. The supply chain improves with every passing week, and we feel good about the future outlook there, a continued growth driver. Biggest surprise again is the moat around this core Americas nonresidential business, this heavy institutional business that Allegion does, where decades of relationships with architects and general contractors, distribution partners, writing specifications, advising on that, using that as your demand generation, pulling your product through that channel. And then once you get that installed base, you hold on to it very, very well. So that, to me, is this just amazingly wonderful foundation to build a growth strategy on top of.

Before we go into more detail, just to expand on it a little bit. You were talking about, I think, just sort of improving user experience of your customer, right? And it seems it's a bit more holistic approach versus product-based approach. And Allegion has done very well with the product-based approach, right, particularly versus competitors. So they've done just fine. But what does this user experience mean in terms of new avenues for growth, sort of adjacencies that maybe Allegion can enter, if you could expand on that?

You bet. And thank you for the question because I think what we're strategically landing on is a recipe that works. And that hardware reputation with the likes of Von Duprin, LCN, Schlage or SimonsVoss, CISA here in Europe, great foundation to build on. And what you see with the transition to electronics is all these products are connected. And -- whereas we've, for decades, done master key systems with metal keys and helped manage that. So this key does everything on the first floor. This key does everything in the building, and manage that with the locks and the keying. The same thing now is transitioning to mobile credentials, and we also manage that for our end user clients. That's a small but rapidly growing part of the business, and it's much more efficient because with mobile credentials and digital identity, you're doing that in the cloud, you're doing that from a PC or otherwise. So there's an efficiency for the end user. The thing that makes me quite confident that we can grow into that space is really that, despite the differences from an elementary school to a university campus to a hospital or even a commercial office building, while the things like you were hearing from Carrier about climate control or smart building type things, those might be vastly different needs for those end users. Everyone needs security and access. That's where we come into play. Our hardware has a great installed base. In many cases, those customers are underserved when it comes to the access control solution that knits all that hardware together and provide you access management, visitor management, these types of tools that interact directly with our hardware. We do some of that business today with our ISONAS Pure Access solution or Interflex solution. We can, and we'll do a lot more in the future.

And so this is addressing more of the existing markets.

So I would see it, yes, as a couple of things, leverage the existing specifications expertise that we've got, leverage the existing distribution channel partners that we've got, because they're seeing the same dynamics, where if you look at a building code, there's division 8 that deals with our hardware. There's division 28 that deals with access control and more of the electronics. Those are increasingly coming together when you talk about a particular construction project. So our channel is building capabilities. We're building capabilities to participate in both. And then I think the idea of the simplicity of a turnkey solution from a single provider, given the application, is quite attractive for a lot of these end users. So it could be share of wallet. It can be more recurring revenue at each opening on top of the hardware sales and revenues that we'd recognize there. And again, with software and services, you have the potential to be on par or even accretive to Allegion margins. It's a recipe that works.

So maybe we can talk about just a little bit more end markets. So across Americas North -- nonresi end markets, what trends you've seen so far this year? And what does the pipeline look for nonresi now versus a year ago? And I guess, what I am trying to figure out, right, if you look at the ABI Index, maybe that is below 50%, up/down. But as I commented on the previous, you guys turn me on to this indicator, looking at muni bond issuance, right? That matters to institutional business. I think the -- I've seen data that shows tax receipts in the U.S. were flat last year. So what are you seeing? What's the picture like for the next 12 to 18 months in the non-res market for you, specifically for Allegion?

Yes. Yes, definitely. So think of Allegion as a late cycle business. You think of any building that's going up, whether it's a single-family house, whether it's a hospital wing or a school, typically, the last thing going on in the building is the doors and door hardware. So late cycle. Also heavy institutional, so think more health care, think hospitals, think university campus, think elementary schools, K-12 education, which is also just within that nonres space, a bit lagging industry. So we're late cycle in the late cycle. Demand is and remains very strong. And I think we see through 2023 very strong demand, particularly around, again, this transformation to more electronics adoption. That's the one part of our business where we do still have elevated backlogs, so doing everything we can to meet that demand. But end user, strong demand throughout 2023. Now we watch those indices as well. In the last few months, yes, they have gone to what we'd say is contractionary territory. We see that. I'd say, given Allegion's position, we do feel like we have a good early warning system. We are late cycle. So in terms of responding to cycle, Allegion's got a history, and we won't change this. So being able to align your costs proactively to meet the cycle. So that I think we feel good about. But demand, Andrew, is really strong. And even in the -- just prior to us presentation, still a lot of legs to go with that federal money for K-12 education.

So that hits you, too, right?

That hits us, too, absolutely. We're quite strong in that segment. And I think the other piece back to the mission and why that's so important, why that drew me to Allegion, locked doors save lives. So when we can do more of that in schools, that feels good, and that's important work.

So does the stimulus change the dynamic of the sort of the non? Because I think that's the big debate. Does the stimulus change to dynamic of the nonresi segment? Because normally, what you would see now, right, so we're still strong, probably would slow into '24 and, probably, I don't know, bottom -- it could be sometime '24, early '25. But you're sort of highlighting, because the amount of funding going to schools is very strong, shall we say. So does that change the dynamic and maybe making some of these indicators less relevant for you or...

I think there are some changes to the dynamic, yes. The other thing that comes to mind is from my past life as well involved a little bit in the earthmoving use of construction. If you go all the way back to the '08, '09 bust, the construction malaise and infrastructure malaise that was in the U.S. was years. There was almost a lost decade of infrastructure investment and construction investment. And I think you're seeing both that just general market come up with also an infrastructure bill, a CHIPS Act, other manufacturing, reshoring, nearshoring type efforts. So there are some rather interesting dynamics going on that, I think, continue to make us believe that, at least through 2023, we'll see strong demand in non-res.

Maybe we can talk about resi, right, because that's another one. As I said, it's just stronger for longer. What are you seeing in the channel? I don't believe -- I think the last we spoke, you don't really have a lot of inventory in the channel, right, I think, on the resi side. So -- but what's your view on resi? How is it holding up? And I know that you're more about completions versus the starts. And completions lag the starts, but completions are also quite a bit less cyclical, less volatile than the starts. But yes, like your latest thoughts on the resi construction market.

Yes, it's a good question. I would say any destocking that we heard about likely happened on the mechanical side in 2022. And so now it's more retail point-of-sale pull-through for mechanical products. Electronic products, again, we had some struggles with our supply chain in late '21, early '22. And again, as more of that gets in the rearview mirror, we still have shelf space to fill with big box retailers on our electronic locks for resi. So that's a bit of a mitigating factor there for us. As well, we are -- to your point, housing completions is the more relevant measure because we are late cycle. But also we're probably 2/3 aftermarket, do-it-yourself, repair, renovate, 1/3 new construction, which, again, the aftermarket side would be a bit less volatile than new.

And speaking about supply chain, right, I mean, I think part of it was availability of the product in the channel. And we were there when Mike was talking about turning -- you were there when you started turning the tide there. So it seems a lot of work has been done. But what kind of implication does it have for working capital in '23, right? You've -- clearly, if we look at your stats, you've been catching up to the competition, to say the least. But how long do you need to keep elevated levels of working capital to sort of make everybody happy there?

Yes. That's a fair point. Let's zero in on inventory. I would say on like a days sales outstanding, we're in a reasonable shape there. On inventory, we did -- definitely, a part of recovering from the supply chain issues was investing in safety stock. I would say, don't look for us to flip a switch and flesh all that out in the next couple of months, but do look for us to improve inventory turns. So think on at least half a turn of improvement in '23, another half of a turn improvement in '24. We feel quite confident to do this in, I think, a prudent way, but not just immediately going back to the levels of inventory that Allegion might have held in '18 or '19. Mike, you want to add anything there?

Yes, I would just -- if you think about cash flow, obviously, we invested in the inventory last year. If you think about '23, we're back to growing cash more commensurate with earnings, right? So from a conversion rate, more akin to normal levels. You saw our guide. It's a substantial step-up in our ACF guide in '23 versus what you saw in '22. So I feel like the initial investment is in the inventory. Don't want to cut the safety stock now. But moving forward, the cash generation of the business still stands where we're going to convert earnings to cash.

Maybe we can just -- so we are in Europe, so maybe -- and just general international, a, I think one notable thing is a big step-up in international margins that seems to be structural in nature. So maybe you can talk about what it is you've done to step them up. And maybe after you're done, we can talk about just sort of the macro in Europe. So yes, maybe we can start how did you get those margins up.

Yes. So I have -- even in these first, whatever, few months, I've been to practically all of our Allegion international sites, all the ones here in Europe. And certainly, Allegion International is on a much more firm and sustainable financial footing, with EBITDA margins in the mid-double digits, commensurate almost with competition who -- this is their home. So we feel good about that. And the way I talk to the team is you're beginning to earn the right to grow. We do know scale is an issue for us in certain markets over here. I think a couple of things have gone on. One, Andrew, we did divest some noncore underperforming assets within the international portfolio. We can't tolerate underperforming assets indefinitely, so that actually needed to happen. The other would be the pricing muscle, really, our hand being forced a bit by inflation. We've started to build up a much better pricing muscle than Allegion International might have had in the past. So definitely not going back to the rather volatile margin to mold. We feel on a more sustainable footing, we do see some pretty interesting opportunity for M&A in Allegion International with a couple of guardrails, if you will. The -- number one, acquisitions that would further our strategy of seamless access; two, have a good ROIC for Allegion. And again, when you talk about growth like we did with plano at the end of the year and closed it just in January, software and solutions and access solutions being a pretty interesting growth trajectory for the company, and one that's also accretive to margins and recurring revenues. Those, we're looking to expand our TAM, expand our addressable market, primarily through share of wallet with customers that we serve today with hardware. That will leverage our specification writing capability and leverage our distribution channel.

And just maybe we can talk, just to finish up with Europe. So I appreciate, so that acquisition will probably change you if you make one, will change your geographical exposure. But my understanding part of it, right, CISA brand, very strong in Spain, very strong in Italy. You have SimonsVoss, that's a specialized product. You have Interflex, that's different. But I always -- some presence in one of your [ card ], right? You have some presence in France and the U.K. But I always thought the strategy was sort of to go into the sort of Central and Northern Europe, to move sort of into the center up north with more product. A, is that correct? And b, how's it going?

So I think barring any specifics, which we shouldn't get too specific, I would say, first off, with the Allegion International, again, on the heels of some very, I think, well thought through divestitures. We'll be choosy on geographic expansion. We won't just go into a new market and expect to organically grow for growth's sake. We'll be choosy on places where we've got distribution strength, we've got product and brand strength, and we've got the ability differentiate. So that being said, there are some category killers, if you will, like a CISA in Italy, like a SimonsVoss in the Germanic region. There is more potential to platform those and expand those out than I think we might have previously thought. So that will be an area of organic investment for us going forward.

And maybe we can talk about market because you were up last week being in Italy and Spain. And how is that going? What are we seeing on the ground? How conservative should we be?

Yes. So again, I think if you talk to European part of Allegion International, certainly electronics and software solutions, the SimonsVoss, the Interflex performing very well and growing. So continuing to organically invest there. In some of the Southern European markets, they're certainly soft. We do have a fair amount of residential exposure there that's a little bit soft. So kind of tale of 2 markets, tale of 2 products. On balance, I would say, again, we're not going back to the breakeven kind of margin business that we had been in the past. And we do look for Allegion International to be a source of growth for us going forward.

Excellent. So maybe we can talk about electronic locks. And maybe I'm wrong, but what I sort of caught on is that, before, I think the focus on the electronic locks and just software was more residential focused with the idea is that, that sort of the leading edge technology and then sort of adopt this technology on the nonres side. It seems the focus has shifted, and maybe I'm wrong, but it seems the focus has shifted more to sort of place more focus on the institutional side on electronics locks and software. And a, what is happening in the electronics lock market overall? And b, how do you envision the strategy evolving for Allegion in this market?

Absolutely. And electronics is again a double-digit growth driver for Allegion today. We expect that will continue for the near term. And I'd say, again, the drivers are convenience, security. And then in the nonresidential space, there's operating cost advantages and simplicity to your building management advantages. So there's ROI in the nonres space. And I think that's also the avenue where we would see the potential to grow software and services is primarily in the nonresidential space. Whereas in our opinion, in resi, electronics are extremely important, and we'll continue to invest in our Schlage electronic locks for resi. No doubt about it. We work very well with Apple, Google, Amazon smart home providers. And I'd say the 2 most common things to connect to your smart home is your thermostat and your lock. And so we do feel like we are a trusted partner of choice for the mega techs. That's important for us to continue to invest in. One trend that you might have come across in the resi space is Matter. It's a common data transmission format that Apple, Google, Samsung and others have collaborated on. We've been at the table the entire time, have a Schlage lock already certified on that open data standard. So that is an important piece for us. But again, resi is maybe 20% of Allegion's business. So certainly, when we talk about organic investment and really growing the core, that's in the non-resi space. Electronics is a secular growth driver there that we look to layer software and access solutions on top of our hardware.

And do you need -- like what would you do strategically, if anything, is there an opportunity on the electronics and software particularly to grow on the commercial side?

Very much so. And I think it's -- number one, it's an organic growth driver for us. That would be the reason why. And I hope everyone has seen our announcement on Capital Markets Day that we're going to host at our U.S. headquarters in early May. Please join. We'll talk a lot more about it there. But I'd say, again, it's the convenience. It's the security. It's the operating cost benefit that the non-res space is going to get that will continue to drive electronics. So if we talk about industry-leading organic growth and above market, above industry organic growth, electronics will be the key driver in the near term for that.

Excellent. So maybe we can talk about pricing. What are you -- what are the expectations for pricing and net cost price in '23? How should we think about pricing? Is it mostly carryover? I guess, the question is, right -- well, why don't we start there?

So really good question. I'm going to ask Mike to jump in.

So Andrew, you know we've been talking about pricing for the better part of the year now because inflationary pressure has been so significant. We're committed to offset inflation by taking pricing actions. We fell a little behind in '21. And then in '22, we've seen significant increase in the momentum of pricing. I feel really good about our ability to have price exceed cost in '23. We did it the back half of '22. That momentum should carry forward to '23. And that's globally, so all of our 2 segments and our products within those segments. So I think we're in a much better place from a price cost such that moving forward, price will exceed cost, both on a dollar and percent basis. And I think we -- some of the challenges we had previously are behind us, and we're in a good place.

And Mike, do you think it -- this is a broader question. This is -- do you think -- and because I think the whole trick was inflation. It becomes sticky, and people sort of have expectations of price increases. And as you talk to both your suppliers and your channel, do you find that there is this now embedded expectation of inflationary pressures going forward? And this is meant to be sort of a bigger picture question.

Yes. If you look at our industry, especially non-res, everyone competes on value, not price. And so historically, always -- we were always able to cover inflationary pressures. I think the channel, the end users, they understand that with inflationary pressures, it's going to be passed along. I think the key dynamic, too, is we're such a small piece of the building footprint, and it's not worth the risk of failure that you're able to maintain pricing discipline in both up and down markets. So I do expect prices to be sticky. Most of them are in the form of list prices, and I don't expect price declines in the future.

So maybe we can jump. I mean, I have a lot of questions. But maybe we can jump to Access Technologies. What has the experience been so far, if you're going to give us an update, progress to date?

Yes. Great acquisition, biggest Allegion has ever done and off to a great start, I would say. So the idea that -- and in fact, I was personally just with a family member in a hospital that had all Von Duprin exits, all LCN closers, all Schlage locks and all Stanley doors. So this portfolio of synergy, when you think about writing specifications, being that trusted consultant to the architect, because they generally don't want to deal with openings, we do that for them. It's a value-added service to them. That means we get to pull our product through the channel and get it on the building, and that also helps our price to be sticky, in all honesty. The lead generation and the demand generation side of that acquisition is going very well. And I think, consistent with the comments that Mike and others made back at the time of acquisition, which closed 6 days before I joined the company, are coming true. Mike, what would you add about that?

I would just say, we love the front-end synergy of Access Tech with our spec writing engine. They historically have not written specifications to a high level. We can now put it in our spec engine and pull it through the channel into the end user. So we really see it as a great growth synergy for us.

Well, and maybe we can finish talking about software. How should we think about Allegion's software capabilities in '23?

So I'd say we have a good base to build on, and it will be a source of organic growth as well as a likely avenue for acquisition. What I'd encourage you to think about is software and services that are related directly with access control related directly with our hardware. So this means software that our channel is familiar with. This means software that again works with our hardware and the end-user application. And in terms of internal capability, this is not probably what you would expect of Allegion. But probably, 60% to 70% of our engineers work in the products of our electronics, our embedded software that goes in the product itself and the software solutions that stitch the product together. Already, north of 60% of our engineers do that today. So I feel confident in our capability to continue to grow there and also make strategic acquisitions that will expand our TAM and do so in a way that is margin-neutral to margin-accretive, even on a rate basis.

So maybe we -- let's see if anybody in the audience has any questions, I don't know. Yes, there's a question.

Maybe I should know this, but I understand you have to be a competitor to ASSA ABLOY, right? And just briefly, what would be these similarities between you and ASSA ABLOY and maybe what dissimilarities are, if you will?

I think, Mike, you can have some comments here, too. I would say it's not dissimilar to -- in my past life with Deere. And construction side of Deere is my last job there competing with Caterpillar, a much, much bigger competitor, et cetera. I'd say portfolio-wise, there's a lot of similarities. A key difference is ASSA ABLOY has their HID system, which is managing identities for our customers. We don't have something like that. But hardware portfolios and things, we would be quite similar. They have much more scale in Europe than we do. We are much stronger in North America, I would say. My predecessor explained an analogy to me that I really liked. He said if you go back to the biblical story of David versus Goliath, we're David, they're Goliath. Okay. Well, thinking how that one worked out, I feel good about our competitive position. Mike, anything to add real quick?

I don't know if I could beat David versus Goliath. But just think of us as a North America-centric business, whereas they're more global than us.

So I think we're out of time. I would not have thought about you, David and Goliath, in North America.

In North America, we're -- we compete quite favorably versus the competition, both in residential and non-res. We're pretty strong.

You're like the 800-pound gorilla to the 600-pound gorilla.

We like that position, too.

Anyway, thanks so much.

Thank you all for your interest. Thanks for attending.