Allegion plc (ALLE) Earnings Call Transcript & Summary

All right. Good morning. Thanks, everyone, for being with us. We are excited to keep the discussions going with Allegion. Thank you so much for joining us this morning. We have John Stone, CEO; as well as Tom Martineau, who is Treasurer and VP of Investor Relations. So the way we'll get started as I'll turn it over to John for some prepared comments. And then after that, we'll jump into Q&A.

All right. Thanks, Joe, and good morning, everyone. Thanks for your time. Just a couple of slides just with an introduction to who we are here at Allegion. What do we do? What makes it special and how we win? I'll bypass this, I think you're familiar with that conversation. So at Allegion, we have a vision of enabling seamless access in a safer world. I'd say what that means to anyone, what that means to you, both as a consumer as well as an investor is that people with the right credentials, whether those credentials are metal keys, proximity cards or digital identities in a smartphone wallet. If you've got the right credentials, you enjoy the most secure and convenient experience possible. Why is that the right strategy, because our world is digital. Our world is mobile. Our world is connected. And so is Allegion's hardware as we'll get into. And I'll have a couple of use case examples just to describe this in a practical setting. But our strategy and how we create value, we are a pure play in security and access solutions. So as we talk about the go-forward strategy, as we talk about the operations, the growth, where we're deploying capital, how we're growing, it's all in and around security and access. I have a couple of elements to that strategy. You see we have a great legacy. We are a house of tremendous brands, brands like Von Duprin, Schlage, LCN, CISA. Some of these brands have 100-year legacies, very well recognized market leaders in their space. But it's not enough just to protect that. We have to build on that legacy. And the way we do that, just over to the side, is delivering new value in access. And I'll talk with you about the secular transformation, the transformation that's happening in our industry right now with the adoption of electronic smart hardware to manage access and manage security. We feel we're a leader in that space, and we're going to continue to invest there, delivering new value and access. Being the partner of choice, open ecosystems are -- rules the world where we operate. So we have to partner with the likes of Apple and Google and Samsung for smart homes, for mobile credentials and smartphone wallets. We partner with a variety of physical access security and video management solutions that also help in the nonresidential space or multifamily space. So being the partner of choice is extremely important to us and being able to operate seamlessly across multiple systems on single campuses. I'll have a use case and talk about why that's important. Lastly, operating with excellence. Allegion has an enviable track record of operating with excellence. We expect and will continue to be, I think, the best operating company in this space and you can gauge us by our EBITDA margins and our ROIC if you want to see proof points of how well we operate and manage capital. Overall business, we ended 2022 just a little bit shy of $3.3 billion in revenue. That was an increase of around $400 million in revenue from 2021. Quite proud of the year we put up. And again, iconic brands, leading market positions, proven ability to expand margins, and I'll close with some points around that because that's very important for where we are in our journey today. And then an enviable position, again, for this technology-fueled growth, which means the adoption of digital identity is really driving the adoption of electronic hardware, which is a fundamental growth driver for Allegion. Our business mix, you see the 3 charts there about 75-25 mechanical to electronic. So while electronics is a key growth driver for us right now. We feel that there's a long, long runway ahead of us. On the business mix, we're heavily weighted to the institutional segment, heavily weighted to nonres in general, about 25% of that to the residential. And this is on a global basis. When you think institutions, think higher ed, think K-12 education, think K-12 schools, think hospitals, health care, government. And then in the commercial space, that's where we would see things like multifamily, residential, commercial office, retail, et cetera. So a bit heavily weighted to the institutional space. On the business mix between new construction and aftermarket, I would just ask you to think about this as a rather squishy 50-50. And so certainly, as COVID went through, supply chain problems came through, Allegion got hit pretty hard in the latter part of 2021, early part of 2022, supply chain is performing much better. Our internal operating efficiency is much stronger than it was. And so we're starting to see more discretionary project wins than we were seeing a year ago. We feel good about that. And our position in new construction is very, very strong, given our long-lasting relationships with leading architecture firms and our ability to consult with them, provide services to them to actually design and specify the openings for the projects that they're working on. There's just a use case example for you. And what this highlights is a number of things. It will highlight the technology-fueled growth opportunity and why electronics are being adopted, why that's a good thing for Allegion. This will highlight this partner of choice and how do you operate in a variety of different ecosystems. And this will talk about, again, this conversion and why the conversion is happening at an end user level. So Auburn University has been Allegion's client for decades, primarily with mechanical hardware, locks, door closures, door frames, doors themselves, exit devices, et cetera. They've made the decision and they've pushed for electronic access control, which means from Allegion, they need electronic locks. They need readers, that hardware and the software that powers it. And then they use companies like CBORD, which is a part of Roper technology or LenelS2, which part of Carrier today to manage access control and other functions. What Allegion can provide is secure credential parity across both of those systems across the entire campus. And when you layer that on top of the hardware that we provide, the card readers, reader hardware that we provide, there are a very few companies in the world that can do that at scale. In fact, there's 3. There's really just 3. We're one of them, and we feel very good about our ability to protect that competitive advantage of that moat, so to speak. What drove this was the university was looking for mobile-first experience. You've got these Gen Z digital native folks showing up on the campus. They want and expect and are used to a more streamlined phone-based digital experience, we can provide that. We generate and manage the mobile credential that these systems use and, again, maintain credential parity -- secure credential parity across the campus. There's efficiency gains for the university here. If you boarded a plane lately, if you've been to a major sporting event or a concert, you likely had a digital credential to get into that event. That's more and more the way access control is going. My own employee badge is a digital identity in my Apple wallet. And I think that's going to continue to drive for us. The tailwind is electronic hardware readers. Just a quick example, an electronic lock would sell for a 2 to 2.5x the price of its mechanical counterpart. So it's a nice growth driver for the business. What can come on top of that, if I'll use a multifamily residential example here is the potential now for Allegion to provide the "full stack solution" to the end user. So looking at multifamily residential is a rather fragmented and underserved market. We can create new value there. So we have the electronic locks. We have just released and talked about last week at the Apartmentalize Conference, a solution called Zentra, which is very easy to use, very easy to set up, easy to install, access control software. That's cloud-native software. It's a mobile-first user interface for the apartment manager and gives them efficiencies because instead of walking around and rekeying doors as tenants change, instead of my front office person having to take every prospective tenants on a guided tour through the complex, they can do all of that digitally from their desk. They can give someone a time-based credential, let them walk around, let them see place. And then the tenants get a better experience. I get secure access to my apartment, I get secure access through my phone to the gym or other shared facilities. And in an area where tenant retention is exceptionally important and probably the differentiating aspect for apartment building managers, this is a nice technology upgrade. It's not a huge CapEx, but it's operating efficiency that they'll get and a better tenant experience. What this now drives for Allegion is the ability to monetize some of the savings we're providing to the apartment building manager in terms of recurring revenue for Allegion. So the software that we will sell gets monetized on a per door per month basis based on the savings that we're generating. So quite an exciting time. And I think, again, in a space like this, as a pure play and access and security, we've got the right to play. We've got the expertise and openings righting these specifications, designing these systems and now increasingly monetizing this on a recurring basis. So in summary, this was the same concluding slide we had from our Capital Markets Day just a few weeks ago. Based on the struggles that Allegion had in the latter half of 2021 and first half of 2022 with supply chain problems, getting behind the curve a little bit on pushing price to overcome rampant inflation, we feel like we've really returned to a high operating level, and we would expect that to manifest itself in 50 to 100 bps margin expansion on an ongoing basis. We feel very confident in that now. Internal productivity, price realization will cover inflation and also the growth investments that we want to make and continue to expand margins. Electronics is our secular growth driver in this industry, and we feel we're a leader in innovation in that space. We are putting particular emphasis on growing our software and service revenues. That was a slice of the revenue pie in our most recent 10-K. It is growing faster than the mechanical portion of our business, and we look to continue to invest there. Capital deployment driving shareholder returns. So in terms of capital deployment, we do expect to invest for growth organically. We do expect to be acquisitive as it relates to access and security. We will continue to pay a dividend. We're a dividend stock today. We'll continue to pay a dividend, grow that commensurate with earnings. We will maintain investment grade. And we will look to be very disciplined in terms of maintaining the industry's highest EBITDA margins and highest ROIC. This concludes the prepared remarks, and we'd be happy, Joe, we can go to Q&A as you like.

Terrific. Thank you very much for that. So to kick things off, you've been the CEO of Allegion for close to a year now. Just talk us through your process a little bit over the past year kind of integrating into your role, objective setting and what you see is most challenging, what you see is most exciting as you set some of those objectives.

Absolutely. So most challenging is pretty easy. So I walked into a company that's a really great success story after being carved out of Ingersoll Rand and tremendous shareholder returns, tremendous stock price appreciation since then. And honestly, following a very charismatic and great CEO, Dave Petratis. That's intimidating and I don't intimidate easily, right? There's a lot there. And plus came in, in mid-July, which was a rather extraordinary time with -- again, inflation was really starting to run, ramp and we knew we were a little bit behind in terms of price realization to cover that. We had some very challenging supply chain situations, particularly in electronics. So backlogs and lead times that were -- or lead times that were normally 4 to 6 weeks for our products. Lead times were a year. It's a little bit crazy time. So replace a great CEO coming into a company that's been a tremendous story, but had run into some problems. So that was a lot to process pretty quickly. But got a great team, a huge amount of expertise in the company. Huge amount of resilience in the company. And the first order of business was just get our feet underneath us on the supply chain side and start executing like we should execute. And I feel like we're there. We're largely there. Factories are doing well. Productivity is turning positive. We've restructured parts of the portfolio that needed restructuring, taking cost out like we should and getting back on this track of driving organic growth and driving margin expansion. So that was really important. Along the way, kind of a nice icing on the cake are employee engagement, just hit an all-time high. So following a guy like Dave Petratis, particularly on something like engaging with people, that was a really nice thing to see. Setting objectives, joe, the main thing that we're looking to do is reenergize growth and do so. I don't subscribe to the mindset that any growth is necessarily margin dilutive. I know we did acquire Stanley Access Technologies that was margin dilutive. However, as we push more into electronics and software solutions, there is, in our opinion, in my opinion, that is the best path for Allegion to continue to realize above-market growth and continue to maintain the best EBITDA, the best operating margins in the industry.

And the supply chain point just sort of level set us in terms of where you are today, challenges that you face, if it is driving any kind of disruptions to operating cadence today and sort of the measures in place now that's what if you had a repeat, that would be advantage, et cetera.

Good question. Good question. And so a couple of things are different. We did invest in some inventory in 2022. So safety stock levels a bit recalibrated. That's one fundamental change. Now that being said, we are committed to about 0.5 turn of inventory improvement this year, and we'll deliver that. Continue to deliver that next year as well. But it would snap back to an exceptionally lean supply chain like we used to have. So a little bit of inventory, a little bit better safety stock level was part of that change. The other part would be disruptions today are much, much less. On the mechanical side, we are, by and large, back to the book and ship business that we're used to. That's where we're driving the inventory efficiencies. On the electronics side, we still have elevated backlogs, even though our supply chain is performing much better. In some cases, we've even doubled production output on some product lines, but still have elevated backlogs in the 30 to 40 weeks' time frame where we would normally be 4 to 8 weeks. So demand there has been extremely strong and extremely resilient. So even though production efficiency, production capacity is much higher, still have elevated backlogs there. The other more substantial investment we made on the supply chain resiliency side, we talked about this in a quarterly earnings call was new manufacturing capacity in Mexico for some of our mechanical products that were previously single sourced from Asia. And as geopolitical and other risks continue to abound, a prudent investment and an investment that over time delivers a cost base that's even lower than we were getting from previously outsourced product by bringing that in-house and putting it into essentially near-shoring it here to Mexico.

And the timing of when that's sort of fully integrated?

Yes, yes. It's ramping up later this year in production and we'll -- anybody who's been around a factory start-up, it never goes as fast as you wanted to. But we'll ramp up later this year and then expect full production volumes to be achieved probably end of '24, early '25 with the ability to expand. So it's not a single purpose-built facility. It's got the potential to take other products or other components that we might need to leverage that lower cost base to help the company's margins.

And just one other point you made in terms of opportunities for growth, and it's not necessarily margin dilutive. If you can talk a little bit about the opportunity set out there and sort of how about can you talk about sort of a focus on sort of electrification as an area that would be maybe most attractive to grow? But just as you think about the opportunity set that might be out there of non-margin dilutive fits into your sort of strategic growth objectives.

Yes. So I think the multifamily example is a good one, right, because whereas in the past, Allegion would definitely be in early with the architect, early with the apartment management company, helping them design, helping them specify get the hardware they need for access and security. When you layer on that access control software, that again is monetized on a per month per door basis. You can see easily scalable software solution. The incremental margin there is extremely attractive. The fact that we're generating like tangible, measurable economic benefits for the end user gives you a right to charge for that. And so I think given access control software, workforce management software, business that we have today in Germany with Interflex, we have a good feel for the kind of margins that you can generate in that software space. And let me just say, it's attractive. And as an investor, you'll like to see that grow.

If we pivot to the Americas business and start on kind of nonres, just I think a lot of sensitivity to what challenges might be out there on the credit side of things or sort of macro uncertainty, but can you just talk about the institutional exposure? What areas of nonres are you sort of tracking most closely right now to sort of keep an eye on any sort of slowing type of potential, anything that you might be seeing out there from bidding activity, negotiation discussion?

Yes. So yes, we are, again, heavy nonres, 75-25 on non-res to res. Nonres has been very resilient, both in terms of sticky prices as well as resilient on a volume basis. That being said, we watch the same indices. We do the same channel checks that all of you do. And we still see robust activity. So sell-through in the channel, both the 2-step wholesale as well as the contract hardware distributor, sell-through is robust. We've put up some outsized growth numbers these last few quarters, and that was a little bit based on burning backlog, a little bit based on a super weak comp because of supply chain problems in the past. I don't think you should look for nonres to grow at 20-plus percent like we've had in a couple of quarters recently. I mean the industry is not doing that, right? The institutional segment, we're looking at it over time. It's a bit more stable, less volatile than something like commercial office or retail. We like that. That's where our service, the value that we provide is probably most recognized. And so the funding sources for those kinds of projects tend to be public non-referendums, things like this, for school districts and whatnot or it's a more large scale -- large hospital-type project that would have large banks kind of funding. Do we hear things that, okay, here or there, developers have hit the pause button because they're just wanting to wait and see what happens with interest rates, what happens with other economic concerns? Yes, that's out there. There's no doubt about it. That being said, we still feel good, as we talked about in Q1. We feel good about 2023. We feel good about the forecast that we've got out there. There are pockets of the country. And if you look at Metro New York commercial office, yes, it's way off. There's no doubt. If you look at the southeast with a lot of other construction apartments and whatnot, it's going like game busters. So pockets of weakness, pockets of strength on balance, we feel good about 2023. Looking at some of the larger indices the ABI or the AIA consensus choppy lately, sequentially choppy. But I haven't seen any of them predicting. We're going to fall off a cliff.

And can you talk about sort of a project cycle and your involvement in that, so where you might shift towards the end, but where you're starting to have conversations in that project cycle? What kind of visibility that gives you? What kind of cycle planning it gives you?

It's incredible as coming from the machinery space, off-road machinery, didn't have a lot of visibility. Here, it's interesting. With Allegion, we're involved with the architects very early even in the design phase, providing a service that honestly we on an increasing basis charge for that we do the design and the specifications for the openings. It could be 6, 12, 24 months from that engagement when we help the design. We write specifications before the construction project gets to that stage because, I mean, it makes sense, right, the door and the door hardware, some of the last things that get installed on the building. So couple of conclusions there for you. One would be once the project starts, it tends to finish. So in terms of exposure to this or the other regional banks is, I would just ask you to think once something started, it's going to finish and we're late cycle. So we do have a pretty good view into market swings up and down. And I think we do have a good track record, and we've been refreshing that muscle with parts of the business today that are under a lot of volume pressure like our portable security business in Europe, like our residential business here in North America, both soft on a volume basis and we're adjusting costs accordingly.

And maybe that's a good segue into resi because I think we've been seeing, at least on the new start side of things flowing for the year, but it hasn't sounded like that's been sort of the revenue trajectory necessarily for you. So just talk about sort of how the resi sort of demand experience you had over maybe the past year? And then how you're thinking about it into the rest of this year?

Yes. Yes. So resi is definitely down, clearly down year-on-year. Volume pressure, particularly on the mechanical side of the business. A couple of dynamics that happened over the course of the last many months is in a rather price competitive segment. We were able to get positive price realization last year, and that's helping. Our residential business is probably 1/3 related to new construction, 2/3 related to aftermarket renovations, DIY, second home sale, et cetera. So some of that has obviously slowed as well with mortgage rates going up. There's probably not as much housing churn. We do engage with the major builders. We do see builder sentiment turning a little positive. I don't know, does that declare a bottom just yet? But builder sentiment is going up. That part of our business, we'll wait and see. But I would say volume is a little soft. We did get price and you do still see an increasing adoption of electronics locks, which is favorable to the business. Again, for your home, an e-lock will sell for 2 to 2.5x its mechanical counterpart. But that's not throughout the house, either, right? That's your perimeter doors where you want that and appreciate that functionality. So that's partially offsetting some of the volume weakness. We did get price in a difficult environment. That's partially offsetting some of the volume. And we'll see. Again, we'll follow the builders, their customers as well. We start to see some green shoots of hope there with permits going up sequentially lately with starts going up sequentially lately. Let's continue to monitor.

Now I'll sort of pull the audience for questions periodically. So if you do have one, just raise your hand. I wanted to touch on the mix dynamic when you talk about sort of the revenue electronic versus mechanical, but the margin profile of electronic versus mechanical, anything to kind of consider there.

Yes. I think the easiest way to think about it is similar margin rate, but 2 to 2.5x average selling price is higher. And then in terms of the total mix, where today, I think 70-30, 75-25, not perfect math there. There's parts of Allegion's portfolio that will never electrify, right? We do make frames, we do make doors, hurricane-rated doors and tornado-rated doors, et cetera. You're not going to electrify a door, right? But the hardware that actually the lock, the exit, the closure, those will electrify and increasingly be connected in smart IoT devices. That's where this is definitely headed. We feel though that electronics adoption, and let's just talk nonres in the Americas segment, is probably still in the low double digits with a nice growth runway ahead. That could easily 3x, 4x from where it is today over time.

And is there a building catalyst around that in terms of getting that penetration from sort of low double digits to something sort of much more meaningful?

Yes. As we talked in the prepared remarks, I think the key driver right now is the smartphone, the digital identity and digital credential in the smartphone wallet, that's what's going to pull through more and more electronic hardware and why it's so essential for Allegion to continue to innovate, continue to invest in generating, providing, managing mobile credentials for our customers and then also continuing to push into software services that help these customers with access control that interfaces directly with the electronic locks.

On that services front and what could become more of a recurring revenue, I think maybe a little bit on Interflex is do you have an opportunity to bring that to the U.S.? Or just talk about sort of any regionalization hurdles.

Yes. So it was -- Interflex is a great business. It's been growing at a low double-digit rate for us. So outgrowth, very attractive margins, a blue-chip customer base, a really nice customer base and got it started. Its roots are really in German labor laws. And then that's how a lot of the software and tools were designed. Is a lot of it scalable? Yes, of course. And so I think it's one of the reasons why -- and we didn't have a lot of fanfare around this, but we did internally organize a global software solutions group that Interflex is a part of as well as our Sonos company here in the Americas with its pure access products. And while there's not -- I mean, they're not swapping code on a daily basis, but I think there's a lot of business model lessons learned, commercial lessons learned, technology synergy that can happen that I think now we're getting organized to be able to identify and capture that.

And then when we think about the sort of electronics ecosystem, you talked about partnering with some of the big tech companies out there. Talk about sort of the moat that you have around the value that you're adding to that system and partnering with some of these larger companies?

I'd say hardware is hard and physical security is intrinsically physical. So Atlanta code is never going to lock or unlock that door behind you in one of those moments of need. There has to be an electromechanical actuation that does that, and that's what we -- and again, a very few others in the world do because you have to have an immense amount of expertise. While it may seem common place, okay, that's a door, how hard can it be. But dimensions, the swing, the torque, the force, the code requirements. Are you in a humid area, you're in a hurricane area, tornado area? All these things go into those specifications. That expertise is not easy to build up. We have it. Our largest competitor has it. Very few others do. The ability to manage literally millions of SKUs in a made-to-order environment because construction projects have their ebbs and flows, right? And none of them ever finish early, I don't think. So being able to ship huge amount of SKUs in a short amount of time, made-to-order environment, that's also very complicated to do. And the channel that you have to use -- the distribution channel that you have to use, those relationships get forged over decades and get forged through having those millions of SKUs and being able to deliver on those kind of made-to-order time lines. So can some guy create a new electronic lock? Sure. But does a hospital want to buy an electronic lock from one guy and then have all this other complexity still to deal with? Or is it just -- is it easier in terms of specifications, making sure my building meets the code to go with this one trusted company and this one trusted distributor that can have all my needs met for my openings and my access. I think that's what now gives Allegion an increasing right to play in that access control layer of software, like we're showing with our multifamily project.

I think we have time for one more. So a margin question. I think it's the Americas margins on the legacy side of the business, excluding Access Tech, I think got back to much higher levels a little faster than expected. Anything from a mix perspective and as we see what's going on with freight, what's going on with raw materials, how you think about anything from, say, a price headwind perspective in the market?

First off, thanks for the really nice way you asked the question. I think you're the first one to tell us we got our margin rate recovered quicker than expected. Everybody else said it's too slow. No, I think, again, Allegion is getting back to a cadence and a sustainable cadence of margin expansion in the core business. Internal productivity, funding investments that we want to make for growth, good operating leverage as volumes recovered and as our shipping performance recovered, we feel good about that. And I think the same will happen with Access Technologies over time. We know how to do this. We know the recipe there. And I think, as we said in our Capital Markets Day, you can look for us to continue to expand margins 50 to 100 bps a year. We feel good about that ability. A couple of reasons why, again, in this institutional space where quality, reliability, code compliance really matters. Those prices tend to be sticky. Our pricing power is pretty good. Our internal operating efficiency, productivity in the plants is back moving in the direction it should be moving like generating positive results for us. We'll expand margins that way too. Then lastly, on the raw mat side, raw materials, we buy a lot of manufactured components, a little bit of raw materials. Certainly, metals are down. We're going to capture every penny that's out there to capture as that flows through. There's always a lag, right? You can't look at a spot rate and expect it to immediately reflect in Allegion product margin because things take time to work through the chain, and we have contracts that provide for certain lags, but we'll capture that as that comes available, absolutely. We're a long way yet, I think, from a deflationary environment, right? Metals are definitely good. Number has kind of cratered. So maybe that's part of the reason for the builder sentiment on the single-family res side going up a bit. And again, I think, overall, the headline would be look for Allegion to continue to expand margins 50 to 100 bps per year.

Great. Well, thank you very much. Really appreciate it.

Thank you, Joe. Thanks, everyone.