Allegion plc (ALLE) Earnings Call Transcript & Summary

Good morning. I'm Tim Wojs, I cover building products here at Baird. And we're happy to have Allegion join us again at our Global Industrial Conference. Allegion is one of the world's largest manufacturers in mechanical and electromechanical security products. From the company, we have CEO, John Stone; we have CFO, Mike Wagnes; and then we have Jobi Coyle here in the front row, who helps with IR. So I think we're going to start with a few slides from John, and then we will get into Q&A. If anybody has any questions, you can raise your hand or you can e-mail [email protected]. So with that, I will turn the floor to John.

Thanks so much, Tim, and good morning, everyone. Thanks for your time. Just a few slides, high-level introduction to Allegion who we are. As Tim said, and I'll work to get one more word in his introduction as well, but pure play provider of security and access solutions. So we're making a big push, and you'll hear more about that to sell full solutions in addition to already great brands of hardware products that we sell today. We have the industry's leading margins. We're in a good industry. Our margins are pretty fair spread above our largest competitors. Broad customer base, broad exposure. We'll talk about that, break that down for you and also a lot of very important strategic partnerships across the distribution channel, with architecture firms, distributors, wholesalers, hardware dealers as well as strategic partnerships with the likes of Apple, Google, Samsung, that are becoming increasingly important as mobile credentials really comes front and center in our industry for access. We have expertise in the Internet of Things and electrification, communications technology and cybersecurity, which is becoming an important tailwind for the adoption of electronic connected hardware. We have a healthy and growing services business, a highly engaged workforce. In fact, this year 2023, our employee engagement hit an all-time high. We have a leading presence, and we'll talk more about what we see transforming the industry, and I really and bullish on Allegion's position and leading a significant portion of that transformation. Finally, we'll talk about capital deployment, our strategy and our approach there and how we want to drive growth organically and through acquisition. Our vision is quite simple. We want to enable seamless access and a safer world. This whole idea that our products, our solutions, our technology can make the world safer. That's what brought me to Allegion. I feel it's an important mission, it's an important work. It makes a meaningful contribution to deliver peace of mind to people where they live, where they learn, where they work, where they connect. We create value there as a solutions provider. That's our sandbox, and we'll stay true to that. If you look at Allegion's business, we capped off 2022 right around $3.3 billion in total revenue. That would break down 70-30 between mechanical products and electronics and software products. That 30% pie, as you'll see on a future slide, is growing faster than the mechanical side of the business, and we'll talk about the drivers why. When you think about the customer vertical mix, we have a very broad base of customers but heavily weighted towards the institutional segments. Think, government, think health care, think education, that's where our specifications, the consultative sales process that we engage in really differentiates Allegion and Allegion's products. Commercial would be kind of everything not institutional. So think retail, think multifamily, we put in commercial, commercial office, lots of other things. So data centers, warehouse, manufacturing, all of that would be in our definition of commercial there and now residential about 25% exposure. New construction aftermarket, about a 50-50 mix. Markets we serve, we see our total addressable market on a global basis right around $40 billion, 3 primary segments that we would look at that market, 2 of which non-res mechanical, traditional GDP growth kind of business, low single-digit growth kind of business, along with residential. Also, we see low single-digit growth. But the most exciting part and where we're investing, both organically and inorganically is non-res, electronics and software solutions. High single digital growth market that's where we want to deploy our capital to grow. I feel very strongly, we feel very strongly that our industry in security and access, even though it may not move as fast as, say, consumer products, but we are on the cusp of a pretty important transformation driven by the technologies that you see on this page. So personalized experiences, the idea that your cellphone is an increasingly important part of your identity therefore, an increasingly important part of your credentials and your access. Edge compute, the hardware that we produce now are essentially in many computers. And when you used to have to have a controller looking after for electronic or electrified doors. The compute power on the locks is growing to the point where that might no longer be needed. And then your overall system, your overall access in security system becomes lower cost, less complexity, easier to upgrade. AI is, I think, in the early stages of making a very profound impact on access and security. And you might have noticed on the 30th of October, just after the close of markets, we did announce the largest, and in my opinion, the most significant investment in Allegion Ventures history, it's a $20 million investment into a company called Ambient.ai. I'd encourage you to check them out and see what they do. We think they're technology leaders in an important space. Lastly is adoption of cloud-based access control systems still in the early stages. We're experiencing this with our Interflex business in Germany. We're helping to guide customers on that transition, and we see that having more implications in the Americas as well. But overall, what the consumer gets, the end user gets, whether it's a university campus, a hospital, multifamily commercial office, you name it, you're going to get higher levels of security, increased convenience, scalability, more automation in your system, so it's lower cost to operate and then easier to upgrade. Upgrades today are very, very difficult. These systems are robust, they work well, but they're also brittle and difficult to upgrade. We think we can fix that in the future. How do we allocate capital? First and foremost, we're an investment-grade company, and we will stay. We're committed to staying investment-grade company. Top priority to invest for organic growth, and that is primarily in this electronics and software solutions space. We pay a dividend today. We're pretty happy with the payout ratio as it looks, and we would look to continue to pay a dividend in the future and expect to grow that commensurate with earnings growth. We will invest in M&A. We will be acquisitive but at the right value that makes sense for us and within the security and access space. We don't look to become a serial acquirer, buying anything that's available just to drive inorganic growth. Finally, share repurchase. We do have an existing $500 million authorization from our Board of Directors. At a minimum, we will buy back any creep from compensation and then use that as a tool as we see that appropriate. Just to wrap it up, and we can talk more about this, but I feel -- and if you've listened to our recent earnings calls, I feel as a team, as a company, as a manufacturer, we are executing at a higher level than we were 1.5 years ago. Electronics is the secular growth driver for our industry, and we see that continuing. Internally, we definitely see great potential to wrap software and services around this great portfolio of hardware products that we have, that becomes the magic. Hardware is really hard to do. And in fact, when you look at our space -- our competitive space, there's only a couple of other companies in the world that can do what we do at scale. And as we can wrap high-margin software and high-margin services that can drive more recurring revenue, wrap that around our hardware products, we feel that's the magic that the future will unfold for us. And then lastly, as I just spoke about capital deployment to drive long-term shareholder return. So try to make that quick, Tim, let's do some Q&A.

[Operator Instructions] So maybe just to start, John, you've been in the seat now for maybe like 18 months. Is that right, 15 months, 18 months, something like that?

Getting close.

And you've had obviously the time now to kind of talk -- get in the business, talk to users, talk to customers, partners, those types of things, like what are the key kind of takeaways you've gone from those conversations, positive and negative about Allegion. And then it does seem like you're making a bigger push into the software components of security. So -- maybe just talk about those 2 things to start off?

Absolutely. And thanks for the question. So yes, I came to a Allegion last July. And if you wind the clock back to last July, pretty dynamic time. Mike was just a couple of months in the seat as CFO. I was brand new as CEO. We had just made the largest acquisition in Allegion's history, likely that generated some questions for folks. And we were in the depths of some pretty tough challenges with our supply chain. We were a little bit behind the curve on price cost and inflation. So in a lot of ways, we needed to just get back on our feet. And I think what I saw positively is the Allegion team is very resilient. Our business model is very resilient. The whole specification engine, the competitive advantage that brings is pretty powerful. That spec engine is always on. It gives us early visibility to projects and work. It gives us great stickiness when you talk about repair and maintenance, break-fix business later on once you're spec-ed into that facility. And it keeps our relationships with end users and that whole network of distribution very, very strong. So continuing to foster those relationships through some pretty trying times was a testament, I think, to the abilities -- the capabilities of the Allegion team. And just great. I'd say I've been to every Allegion site, save our facility in China and Australia. Great employees, great team and again, super proud that 2023 sees the highest employee engagement ever.

Okay. Okay, good. And then just -- you talked a lot about software maybe just elaborate around why now, what you're trying to build? Because I guess the security kind of infrastructure today or the go-to-market is still very complicated. There's a lot of third-party providers, open providers. So how do you see Allegion fitting into that kind of existing network?

That's a great question. And I think a huge potential for Allegion, and I'll come at it from a couple of angles, #1 is the channel power that we have, when you look at our industry space, again, it's a good industry. There's -- again, there's only a couple of companies that can do what we do at scale in terms of managing a huge portfolio of mechanical and electromechanical products doing that in a made-to-order environment, writing specifications, being that consultant through the architect and the general contractor and even the end user to help them design access and their entries and openings. That's tough to replicate. The channel power that brings makes me pretty confident that we have the right to play in some of those next layers of the solution set, if you will. The fact that we're investing heavily in our own electric and connected hardware. These are little mini computers on the doors now. They're doing a lot of thinking for themselves. They're encrypted. They have several encrypted handshakes with a smartphone to let someone in or out of the door, log that data, provide that data back to system. We know a lot about this space. And I think when you see the investment we made organically in our Zentra tool, which is specifically targeted at multifamily access control and visitor management, it's a very light-weight tool. It's an easy install, easy implementation, that is revenue generating today. It's cloud native. It's a mobile-first UI. It works seamlessly with our hardware on the doors. It just gives our distribution. It gives us as the manufacturer a full solution set to provide to what has been a pretty much underserved market. That's our primary organic investment right now. And I would agree with you. There's a lot of companies in that software space. I think many of them sitting on very old technology, it's too fragmented. And I think those inefficiencies that you kind of called out in your question, Tim, that's an opportunity for us to bring a better integrated solution set to the end user with a single line of accountability for customer support for install for service and maintenance, et cetera.

Okay. Okay. And is it -- are you willing to kind of buy into the new technologies to kind of get those capabilities? Or -- do you feel like you need to have a legacy presence to kind of get the customer kind of base? Or do you feel like you can do this all kind of organically? I mean I had 3 options.

Yes. I think, again, I highlighted where we saw a great opportunity in an underserved segment in multifamily to come with an organically developed product. I think in any of these spaces -- it's going to be a combination of build and buy. So there's certainly more that we'd like to do on the acquisition front and looking to deploy capital to grow. We see it also the software, the services space as the best potential for margin accretive acquisitions, which is tough to do for a company like Allegion. Our margins are very strong. But that space, we feel has good potential to even be margin accretive.

Okay. Okay. And I guess, how do you think like on the M&A side with them? I mean, how do you balance the fact that you've got incredibly high market share and maybe the highest margin parts of security or kind of anything you would buy is probably going to be dilutive. With expanding the strategy and trying to grow inorganically as well. I guess how do you balance those 2? I mean what takes priority? Is it margin? Or is it strategy? Or is it the product set?

So I think long-term shareholder return has to drive us, and that's what we're looking at. We're playing the long game here. Just like we did with the Stanley Access Technologies acquisition, Automatic Doors was a long-standing portfolio gap for Allegion. It was slightly margin dilutive, but I feel the company as a whole, including the acquired business has done a good job, expanding margins over the last 5 or 6 quarters, we'll continue that. We delevered very quickly. So I think the balance, Tim, is still long-term shareholder return, superior returns. We can do that. And again, in our sandbox in security and access. We have the expertise. We have the distribution channel, we have that channel power, and I feel like we've got a right to play and a right to win. And the software solutions, service solutions can and I think will prove out to be margin-accretive acquisitions for Allegion.

Okay. Maybe on the electromechanical side, just maybe just kind of big picture, kind of where we are in that journey. Electromechanical is growing faster than the mechanical parts of the business. But where are we kind of in terms of the penetration curve in resi and then also on the commercial side of the business?

Yes, I think consistent with -- if you looked at any of our Investor Day material from May, you could think of adoption rates in our core markets, Western Europe, North America in the low double digits. We feel that's still got a pretty long runway of adoption. Our end-user checks, again, particularly in this institutional space would validate that. I've visited several large universities recently and electronics adoption there has been an ongoing journey. So we've got long-standing relationships with universities who adopted e-locks, 6 or 7 years ago that are now on their next cycle of upgrades. It's another kind of important part about the electronic space for the electromechanical hardware is -- it's no surprise that a circuit board is going to wear out quicker than the mechanical assembly. So the life cycle of an electronic lock will be in single-digit years, whereas the mechanical lock could last decades, right? So you get your average selling price about an equivalent margin rate and a quicker replacement cycle for these as well. And talking with the universities, talking with other institutional clients, multifamily clients, the budgets that they get, they're putting towards electronic hardware to increase security, increase convenience.

Okay. And then how much of your revenue today is product based and how much of it is recurring service? And I guess, how do you think of that relationship kind of evolving over time?

That's a great, great question. We put that in our 10-K at the end of 2022, and it's low single-digit percent today in terms of what is that software service recurring revenues. We see line of sight to that growing pretty robustly here in the future. And again, it's point of investment for us, both organically and through acquisition.

Okay. And then the spec business, kind of like the unheralded champion of the business. But -- just maybe talk about the advantages of that business, how hard it is to build, how hard that can be to kind of replicate and what it kind of gives Allegion in terms of the go-to-market advantage?

Yes. It's a great question. I would tell you some of the most impressive talent I've met in Allegion is our spec writers team, and we've got a development program, bringing new talent from civil engineering programs all over the country into that. It's a great place to learn the business. So these young folks are coming in, in a good spot. But the advantage is -- and from -- like I came from off-highway machinery into a business that literally specs their products into the project, into the building, into the campus, which does a lot of things for you. Number one, you're taking a burden of detail off the architect that they don't want to mess with anymore. So it's even becoming and increasingly paid for service that our folks do. It's incredibly detailed work. It deals with a lot of change management because it comes towards the end of the project as well, there's a lot of complications to deal with. So we have a software tool that cloud to cloud interacts with the architect and the civil engineering software, exchanges that data, keeps a record for them. So when you talk about brake fix, it's also an advantage there. You can go back and see exactly what was on which opening. It also gives us, obviously, early visibility to work, early visibility to demand creation and future sales. It keeps us as the trusted adviser to these end user clients because it's -- again, it's detailed they don't want to deal with, but it's also code compliance, safety and security. And if you're running a university or you're running a hospital, you're running a school, you can't compromise on those things. So once we're spec-ed in, you can also realize that does pretty powerful things for your price realization as well. And you think on our hardware being a very low single-digit percent of the total project. Also has an impact on code compliance and getting your certificate of occupancy. So the cost of failure is very high. But the cost of our hardware relatively speaking, is a modest amount of the project. It's -- I think it's a great spot to be in, and that spec engine is really the secret sauce that differentiates us and then creates that proverbial moat around Allegion.

And maybe just size wise, like how would you compare yours to your Swedish competitor or maybe some of the other smaller guys?

I think in the Americas, we're by far the biggest. And in our international business, we've been making very targeted investments, sometimes in country and sometimes leveraging our engineering center in Bangalore, India that now has -- I'd say pretty good skill set, pretty good capability set there to help with specifications on the international side, too.

Okay. And then I guess, thinking about the spec business, like what is it telling you about '24?

That's the definitely the question of the hour. And I think consistent with what we shared in the recent earnings call, we still see organic growth, primarily driven by the institutional segment. That segment is quite resilient. That segment if you look at the -- monitor the ABI and disaggregate that a little bit, it's still north of 50 and has been 5 of the last 6 months. Channel checks would tend to back that up. So on balance, we still see organic growth. Now you also heard us say and we still believe this, our residential business is soft. We're not counting on a huge snapback in that part of the business. Commercial office and some major metropolitan areas is soft. We've been talking about that several quarters now. Go around the world. Our electronics business in Europe is very strong, still double-digit growth. The residential markets, the other mechanical markets a little soft, not so great. China, we mentioned it's very small for us, but it has been quite weak.

Okay. And there's a question here from the audience. What level of declines in commercial new construction next year can happen for you to still show kind of flat to up kind of overall organic growth?

Yes. So maybe the way to think about that, if you remember the slide, 40% institutional, 25% resi and then the balance in commercial. And commercial has a lot of buckets in there. So you've got multi-families in there, commercial offices in there. Retail is in there, which now with our automatic doors, from the Access Technologies acquisition, that's a little bit more prominent, but data centers, warehouse manufacturing, all that is lumped into the commercial segment. So commercial office, think of that as low double digits. If that bucket is 30, commercial office would be probably a little low double digit.

Of the total company?

Of the total, yes.

Total business, okay. Okay. Good. And then I guess as you think about the relationship between price cost, you talked about just kind of coming in and maybe kind of played a little bit of catch-up. It seems like that's normalized and maybe handsome or maybe it's just normalized. But -- how do you think of that relationship over time? Because I always think of Allegion as a company that normally would kind of price for value. That usually is a pretty decent tailwind for the industry kind of absent big moves in inflation. So -- any change to how you kind of think about the pricing environment at Allegion?

At a high level, I think we would see that inflation has certainly come down. And seeing the levels of inflation, the levels of price realization just both moderate a little bit. The way you can think about Allegion will continue to drive an equation of price plus productivity is going to more than offset inflation and any incremental investments we make. So that will be a positive equation, and we will continue to expand margins. I'd say on the productivity side, we're just starting to get our groove back in the plans as the supply chain has improved. So we see more efficiencies and things inside the business there. But on balance, we expect to continue to expand margins over the near term, 50 to 100 bps per year. And we do price to value. That's very important. We put a lot into our products in terms of durability and reliability. Our Vitality Index is also now headed back in the right direction. After dual sourcing work and redesigns for different chipsets and these things, our engineers are now back fully on new product development. We've got a good pipeline coming and that also continues to let us price for value. Anything price/cost. Mike, do you want to add?

I would just say if you look at our history, clearly, we fell behind in '21 and early '22. What you see here is some catch-up, right? In total, we feel really good about our ability to expand margins. We talked about it on the third quarter call. And if you think about Allegion, our history has always shown our ability to expand margins as we grow. We expect that to continue. So as you think about next year, you can see an environment that's normalized, where pricing is not the double-digit pricing we've had some of the quarters this year, but it's a more normal level of pricing to match the corresponding level of equation, because we are in an inflationary environment.

And then historically that pricing has been pretty sticky, right?

Very. So especially in our nonresidential business, it's been a very sticky pricing, dynamic where we're able to price for value that we provide our customers.

Okay. And then just on the investment side. So since you guys spun out back in -- was at 2013, you probably put like $150 million, $160 million of incremental investment like into the business. How do you think like that investment cadence going forward? I mean, it's something you guys used to disclose in your case, but how do you think about the absolute bucket of investment in terms of dollars of incremental investment per year?

Yes. As I think about it, our equation is price plus productivity versus the inflation and investments. And we have to drive the productivity to fund that level of investments. We want to continue to invest in organic growth. So don't look for us to cut investment look for us to continue to invest in our business, but we're going to fund it by driving productivity actions in the organization.

And some color, Tim, as to where that has gone. Our engineering staff has probably doubled since then, head counts doubled. A majority of that happening in Bangalore, India. Our investments in human capital have also reached the point to where it's on the order of 2/3 of our engineers are in electronics and software development. So that's software that goes like inside the lock itself as well as application software that interacts with those locks. That's been, I think, an increasing trend and will continue. We're pretty proud of the capabilities we've got, and we've got more to continue to invest in there.

Okay. And then just real quick, maybe the last one, just the Access Technology acquisition. What were kind of the key -- like I mean, obviously, the biggest deal you guys have done as a public company. What were the key like kind of learnings positive and negative to that business?

Yes. I think long-standing portfolio gap, complementary market exposures to where Access Technologies was quite prevalent in retail, and our core Allegion business maybe was not so strong there. Where the core Allegion business is strong, again, in these institutional spaces, so hospitals, universities, et cetera, that complementary market exposure, really good sales synergies opportunities, plus the spec engine. Stanley had very little, almost no capability in writing specifications. We can bring that in. And if you would follow the history of like TGP and AD Systems acquisitions that Allegion made a few years back, that spec engine has really driven the growth in those businesses. It's a great story, and we'll see the same with SAT.

We're out of time. So please join me in thanking the Allegion team.

Thanks, everyone.