Allegion plc (ALLE) Earnings Call Transcript & Summary

Allegion. John Stone, President and CEO; and Josh Pokrzywinski, who recently joined Investor Relations a couple of months ago. So welcome to both of you. Thanks John and Josh for being here. I think, John, you had a couple of sort of intro remarks just to get through and then we can switch to Q&A. So thanks very much.

Yes. You bet, you bet. Thanks for hosting, Julian. It's really good timing for Allegion to be here. We released Q4 and gave our 2024 guidance Tuesday of this week. Very proud of what the team accomplished in 2023. It was a record year by almost every measure. Record revenues, record adjusted operating income, record EPS. So really proud of what the team put together. And as you heard on Tuesday, we think, 2024 is going to be better. You know Allegion has a strong market position in a good industry. And in that good industry, we, by far, have the highest margins. We don't feel like we've hit a ceiling, there's [Technical Difficulty] on the call. The secular trends that are driving electronic hardware, connected hardware adoption with the continued and increased use of digital identities and digital credentials, that's still underway. That's still driving growth for Allegion. And then we feel very strongly that we're an innovation leader in that space. Cash flow was very strong this year, going to be better in 2024. As you saw on the earnings call, very balanced, very disciplined capital allocation to profitably grow the business through acquisitions as well as direct return cash to shareholders. And I think it's very much within the realm of possibility to see more quarters like that from Allegion going forward. So we're excited about what the future offers. You add all that up, I think we're one of the most compelling companies here.

Fantastic. Thanks very much, John. And maybe just start off with organic growth outlook, let's say, for the year ahead. I think you talked about sort of the Americas, let's start with that. The residential market, sort of not much growth there, more on the non-residential side. So maybe sort of [indiscernible] out in nonresidential kind of what you see as some of the headwinds and tailwinds. You've got a very strong market presence, so you have a good sort of feel of different verticals.

Yes, I think consistent with the call on Tuesday, when you roll it all up, now we see organic growth between 1.5% and 3.5%. As you disaggregate that, you're right, we don't see a lot of market tailwinds in the very near term in residential. So we see that as flattish to maybe down a point. In the non-res side, we highlighted in the call, Dodge starts in the institutional segment are still positive, and starts can lead our business by a year or more in some cases. So our demand generation model in this classic pull strategy we have through distribution means we have kind of a steady stream of business there, through the aftermarket, through new construction and institutional. On the commercial side of nonres, that's where you've got more of a mixed bag. And so that's about 30% of our Americas business, and we tend to bucket that as like 1/3, 1/3, 1/3 in multifamily, commercial office and then everything else. And everything else would be things like retail, data centers, warehouse, manufacturing. So some strength and weakness in that other segment. Multifamily and certainly commercial office, we've been talking about this several quarters in a row, it is under some pressure. But don't forget, half our business is aftermarket, which tends to be pretty stable as well, and we would see that continuing in 2024.

Perfect. And when you think about the sort of multifamily and office piece, I know that's something that investors are always focused on with Allegion, for example, and some other companies, how well is that aftermarket holding up, or how well has it held up, say, last year when greenfield started to come under pressure? And do you sort of think it carries on holding up well from here?

I'd say aftermarket in general is less volatile than new construction. That shouldn't be surprising. And I would say that holds true in multifamily and in office. So while you might not see a lot of new office towers being built in big cities, you do see tenant turnover from time to time and repurposing of space, and that's still a good business for us.

And on the pricing side, I think you've always had very good pricing at Allegion in different environments of inflation, more or less. [ Leaving out ] pricing in areas like mechanical, residential and commercial, multifamily and office, do you see more pressure because of volume pressure in greenfield, or not necessarily? Like, the degree of price pressure is [ different ]...?

I think certainly, and this would be consistent with past comments as well, our market position, our pricing power in the non-res space is stronger than it is in residential. So I think the fact that we're consulting on the design, we're in early on the design with the architect. We're listening to the end user, understanding their requirements, and then specifying a solution set to the value that they need. And then it's important to remember in a building our products is relatively small piece of the total construction -- total building cost, but it's also very, very critical to get your certificate of occupancy and meet your codes and standards. And so it's not the place that your GCs are going to try to value-engineer you to something cheap. It's too risky there when you're ready to hand the keys over to the building. So that helps the pricing power as well. And in general, this is a good industry. We price to value. We keep the product line fresh, and the fact that there's only a few of us that can manage millions of SKUs in the made-to-order environment, I think, helps reinforce that pricing power.

And when you think about those cycles in, say, multifamily and office, and then -- I assure you I won't keep asking about those 2 verticals -- so last one of those is around, when you look at the historical experience of those down cycles, how long do those tend to last? Kind of when do you think those verticals may bottom out on -- for multifamily and office?

Yes, I'd say we watch the same indicators that you do, and as you disaggregate something like the ABI, you've seen multifamily, commercial, office below 50 for a while, which we never read too much into those indices, but you also don't ignore them. And so I'd say calling bottom, we're hesitant to do that on any particular segment at any given time. I think we're interested in always striking that balance between new construction and aftermarket, striking that balance with the conversion from mechanical to electronic systems, which tends to reduce the overall volatility and buffer Allegion against any macroeconomic cycle. Over time, we've performed well, I think, against up and down cycles, and broad end-market exposure, broad portfolio helps us do that.

Fantastic. And more broadly across Allegion, a lot of sort of ups and downs with inventory adjustments by your channel partners. So I guess a couple of things. How satisfied are you about inventory levels now across the channel partners that you serve? And also is there a way of getting more visibility into those channel partners, or it's just the last 2 years, it was impossible because they didn't have the visibility either on demand swinging around and supply chain moving up and down.

Yes, it's a good question. And I think the -- it's hard to overstate the disruption that those supply chain problems had on our industry because, again, we're typically a book and ship, made-to-order business with order lead times in the 2- to 4-week range for most of our products. That got completely turned on its head in late 2021, early '22, and was difficult for the entire industry to overcome. We mentioned on the call, we do see that that's mostly in the rearview this point, getting back to that book and ship business. Publicly [indiscernible] have been normalized for several months now. Ordering behaviors with our channel have also a rather normalized. Our own inventory performance is a lot better. And we see continued incremental improvements on inventory turns and working capital management. So I think it was a temporary phenomenon, but I think it was extraordinary for the industry, but I do feel like, collectively, I would just say getting back to normal.

And I guess, on a sort of stimulus front, Allegion has been more prudent perhaps on sort of managing expectations around tailwinds from things like Inflation Reduction Act or IIJA in the last couple of years. Have you seen much in the way of any effect on that on your business? Do you expect much stimulus tailwind in the future? And there's 2 broad programs and then also the [indiscernible] in education, any thoughts around the scale of that helped your business, if any?

I think, of course, yes, to some extent. But as we've shown, if you look at our Americas business, roughly 45% of that business is in the institutional segment and then 30% Commercial, and in that Commercial space, things like the Infrastructure and Jobs Act put $25 billion towards airport terminal refresh. That's a good end-user vertical for us. We've implemented end-user standards for many, many airports. The addition of our automatic doors with STANLEY Access Technologies even complements that portfolio. I'd say within education, it's probably more closely related to just the ongoing turn of municipal bond offerings, that '22 was an all-time record. In 2023, the bond offerings were down 2%, so down 2% off of an all-time record is nothing to get too excited about. But I think the work that we do with end users and with architects and general contractors very early on in the project phase tends to have our products spec-ed in. Once you're spec-ed in, people tend to respect spec. So any of those stimulus dollars that come down and do get allocated to security and access, where we're a pure play, certainly provide some tailwinds.

Fantastic. And then away from kind of the cycle aspects, the electronics push, I think, again, supply chain noise behind you now and that. So you saw kind of very, very strong growth the last 2 years, like 20% -- plus growth in 2023 there in electronics. Now we've sort of calmed down on supply chain and so forth. What should investors expect that portion of Allegion to grow this year, for example, in the next...

Yes. Probably not going to give a pinpoint number for you there. I would say what we need to look at is we feel this is, as we talked at Investor Day, over the medium and long term, it is a high single- to low double-digit growth driver for Allegion. And we see some very interesting bolt-on acquisition opportunities in the space as well. Tailwinds are really driven by a couple of things, mainly it's the adoption of digital identity, digital credentials, mobile credentials in your smartphone, driving adoption of electronic locks and electronic exit devices, and then complementing that with other products that maybe we don't have in our portfolio today. I think we can capture even more of that growth. It's also not surprising that an electronic lock will have a shorter life cycle than a mechanical lock, right? So the replacement cycle is shorter instead of a mechanical lock that can conceivably last decades. The electronic components, either through the need to upgrade for better cybersecurity or upgrade to a Wi-Fi connected offering, or just the circuit board has burned out quicker than the mechanical assembly, then you've got a shorter life cycle, greater replacement cycle there. So also kind of a nice tailwind in that space.

And within electronic security, I guess, for 10-plus years, people worried about a shift in where value goes in that [ chain ], maybe internet service providers seemed to take an interest 5 to 10 years ago. But it feels that the competitive dynamics are pretty stable on the whole, and you didn't see value move around much in the chain even with the emergence of ISPs for example, in home security or what have you. Is that kind of a firm assessment? And maybe how is your thinking on electronics adoption, pace of it, drivers? How has that evolved? How has Allegion's view of that evolved, let's say, in the last couple of years?

It's a great question. And again, it's one of the main secular drivers that we see as key for Allegion to continue to invest in, be an innovation leader and drive growth. If we look at -- we'll hit the competitive dynamics first, it's a great question. So you know the competitive dynamics in our space. There's literally 2 other companies that do what we do at scale. If you look at the space of access control software, you can go to our Investor Day deck from May in the appendix, and you'll see the myriad of companies that we are a hardware partner of choice for. So quite a fragmented space there. Then probably the next layer, if you will, in the technology stack, would be video surveillance and the AI on the back end to start to make security from reactive to proactive. And all that kind of interacting together, and I'm talking about non-res space, not residential, is your overall solution set, depending on your needs. Allegion is positioned very, very well, I think, in terms of our hardware position. I don't see software companies, ISPs, I don't see them trying to get into electronic hardware and compete with us. It's just too many -- too much investment there, the barriers are quite high. That also gives us distribution channel strength, end-user relationship strength, because we have these relationships for decades. We've helped design their entry, egress, advocate for proper safety standards. And as there are new offerings, let's say, software offerings, in the access solutions arena -- so it could be access control, it could be something like visitor management, temporary credentials, there is good potential. And I think for a company like Allegion, we would be looking at early-stage companies with good products, good management teams and solutions that need distribution, and we can help with distribution. These early-stage companies typically struggle with that. Early stage also means a company of Allegion's size likely can afford to make an acquisition or 2. Just like we did with Plano a year ago. Great tuck-in. It was a bolt-on to our Interflex business in Germany. Interflex provides readers, access control, time and attendance for hourly workforce. And then Plano is a workforce management bolt-on to that. So [ just a ] module you can buy, it's a SaaS offering, it's accretive to Allegion's margins even though the size right now is relatively modest in terms of top line. But bolt-on acquisitions like that and high-margin software solutions that interact with our hardware feels like a very good growth factor for Allegion to continue to invest in the electronics adoption space. Pace of adoption is still going. As we showed at Investor Day, I think low double-digit percent adoption. We see that has the potential to 3x or 4x over the long term. It doesn't go to 100%, of course, because you're not going to electrify the door itself, right? So the key hardware items that can be electrified and connected. A long-winded answer. This is an exciting space, and we've got a lot going there.

And the sort of -- Allegion historically a lot of replacement work, as you said, 50% of sales. Subscription-type models, somewhat similar to that, but also different business models, kind of how have you found running those subscriptions and SaaS offerings? And should investors think that you might do a larger acquisition there, or in general, because of valuations and just financial metrics, the sort of smaller stuff makes more sense?

Great question. And yes, to the second part of your point. I think if you look at Access Technologies, STANLEY Access Technologies, that would be a large acquisition for Allegion. It closed a week before I took the job. So it was quite interesting to integrate that very large acquisition and delever. And I think we've done a good job there and the business is performing quite well. What that brought with it, though, was about 40% of that business is services. And now if you look at Allegion's portfolio in our 10-K, up from 29% in 2022 to 33% in 2023 is electronics, software and services. We see that piece of the pie continuing to grow. But again, I want to frame everybody, the way we see this is where Allegion can play, add value, profitably grow would be early-stage companies that smaller bolt-ons, something like Plano in the software space. Like we did with Boss Door Controls. And that was very much a channel strength play to get us into more spec-driven business, architect-driven business, but it was hardware. And I think in our space, we see those types of acquisitions being a bit more actionable than they have been over the past 12 or 18 months. And I think it's most important to say what we always say in this part of the commentary, is we will be disciplined. And that means single- to very low double-digit EBITDA multiple on a hardware bolt-on. And on an early-stage SaaS company like Plano, relatively speaking, the multiple will look high, but in terms of affordability for a company like Allegion quite reasonable.

With good returns.

Yes, with good returns. If you look at these hardware tuck-ins that we look to do, and Boss in particular, I mean, double-digit ROIC right out of the gate and something that by year 3 is probably mid-teens. That's the kind of discipline that I think we will -- [ sort of the key ].

And those return metrics, those can work for both sort of hardware and the SaaS by year 3...

Absolutely. If you look at Plano, again, think 1.5 to maybe 2 points of revenue for Allegion International, but accretive to Allegion's enterprise margins.

Yes. Okay. And you don't need sort of a huge dollar kind of investment to scale it. It can run with good margins and decent growth from the beginning inside the...

Yes. I think that's the other attractive piece of these early-stage companies, that we can scale without the kind of incremental investment that the early-stage company would have to do on their own. We have 600 people out in the field for sales. We have decades-long distribution channel relationships and end-user relationships to help with customer acquisition and profitable growth. The synergies are, in my opinion, quite strong. And it's a very attractive growth potential for Allegion. Again, with discipline on the valuation and acquisition price.

And who do you sort of compete with to buy something like a -- like is it the traditional other big 2 -- are there newer entrants, private equity-backed roll-up vehicles? Like what's the sort of landscape of buying that versus the hardware acquisitions?

I think certainly, it's a range of investors. Private equity plays a role there from time to time. Family investment funds play a role there from time to time. Sometimes it's just founder-led investment. We're very choosy as a pure-play in security and access. We're not drifting out of that. We're staying in our sandbox because that's where we've got expertise and the ability to scale. And so typically venture-backed, private-equity backed, family-fund backed.

Sure. And that 1/3 of total Allegion revenue that's electronic software and services now, any sense of sort of how do we think about sort of margin rate of that versus the total company operating leverage for that 1/3 of the company.

I would call it good. It's not on the upper end, let's just say.

And on that point around -- people often ask, your Americas operating margin is back to sort of very, very high -- close to 30%. It's hit that number a few times, I guess, in the decade since spinning out. I think you've said that's not a ceiling. There's nothing magic about 29.5% or whatever as a ceiling. So from here on, thinking about main drivers, kind of volume leverage, is there a mix tailwind from that electronic software services piece as well? Any thoughts around that kind of operating leverage from here in the Americas?

Yes. In aggregate, Julian, I would just go back to the 4Q call. And it still comes back to price plus productivity in excess of replacement in that [ space ]. We will maintain the pricing discipline to cover inflation if we experience that. We have good momentum, good muscle around just self-help productivity. We do run lean and we see good potential for productivity gains in the very near term. We did take some cost actions even in -- at the end of Q3, early Q4 2023, to help us support that. And this continual stream of new products with the added upside of disciplined and consistent capital deployment. That's the recipe. I don't think it's anything different than you hear from a lot of other companies. But I think with our market position and our industry structure, we're in a very good position to deliver on it.

So when we think about the 2 segments that you report and your operating margin expansion potential, are they sort of fairly similar to date just year-on-year margin expansion that we should expect between international versus Americas, are they like a comparable increase over time?

I think you can look at the course of 2023 -- and we do break that out and show margin expansion by the reporting divisions. Both divisions did very well in 2023, and we expect both divisions to deliver going forward.

And in international, are you sort of satisfied there with the scale of it, or do you think to get margins up, you've got to do 2, 3 [indiscernible] acquisitions and then your margin entitlement moves up to the 20s let's say once the scale is there.

Yes. I would attribute it more to -- and again, back to the call comments -- a very disciplined focus on portfolio quality in international versus pure scale. I think past, if you wind the clock back many years, Allegion International was probably too myopically focused just on scale and not enough on portfolio quality. So acquisitions like Boss Door Controls is great one. Great tuck-in. And again, good ROIC right out of the gate, synergies are going to start right away, and it was a channel strength play for a spec-driven architect-driven business. Good portfolio quality is what we're after, not chunky acquisitions just to get bigger.

That's reassuring. And then I think we have to switch now to the audience response survey questions. So if you could grab those gray devices, please? And the first question should be around ownership. There we go. Do you currently own the stock...?

I'm suddenly very nervous.

So that's a good thing, a lot of opportunity there. Number two, question around sort of general previous position towards Allegion at present. It's a fairly balanced neutral on the whole. Number 3 is around kind of expected earnings growth against, say, the multi-industry average over time. So in line with peers overall. Next question is around excess cash usage. There's a broad list there. So generally bolt-ons and buybacks. And I guess on that point...

I like this crowd. Every company leads with internal investment as their key priority -- I sure like this crowd.

Next question. [indiscernible] -- deal with -- for Allegion. Sort of high teens '19, '20 times. And then the last question is really around sort of what's the reason people don't own more of Allerion's shares today.

Okay. So organic growth is the main aspect.

Perfect. Well, thanks so much, John and Josh for being here. Thanks, everyone. Thank you.