Allegion plc ($ALLE)

All right. Good morning, everyone. Welcome to Allegion. This is Tomo Sano, Mid-Cap Industrials at JPMorgan. Today with me, Mike Wagnes, SVP, Chief Financial Officer. Thank you, Mike, for joining us. And let me start by sharing why Allegion is such a relevant participant this year. Allegion is a global leader in security and access solutions with strong positions in nonresidential and institutional markets and a clear strategy to accelerate growth in electronics and software-enabled solutions supported by iconic brands and robust free cash flow. So with that, Mike, to kick things off, I think it would be helpful to start with an introduction to Allegion, who the company is and what you do and your story, please.

Thank you. Thank you, Tomo, for hosting us, and thanks, everyone, for joining us today. I got to make sure I talk into the mic. So at Allegion, I'm going to spend a few minutes just kind of going over overview. Tomo did a quick synopsis. I'll also do a quick overview, and then we'll just do Q&A. We'll start standard traditionary cautionary statements. Just take a look at our 10-Ks and 10-Qs related to disclosures related to non-GAAP and the reconciliations and forward-looking statements. Allegion, we're a global provider of security and access solutions. As Tomo said, iconic brands, think about it as Schlage, Von Duprin, LCN. If you're in your home, happy in the room, probably have a Schlage lock. You go to your child's school district, you'll see our products littered throughout that school district. So we are a big player in nonresidential and residential. Obviously, for us, nonresidential Americas is our biggest business. We are -- one of the things about our business is we do a very credible job of expanding margins over time. We are a high-margin business, right? We got $4 billion of revenue, 25% EBITDA margins, and we expand them over time. And it's something we talk about at all our earnings calls, about our ability to leverage volume, expand growth, drive productivity and pricing. And also, one of the things the last few years, I came here starting in '22, a few months after me, our CEO, John Stone, joined the company. Our ability to accelerate capital deployment over the last couple of years has improved. And so we're a consistent capital deployer to the benefit of shareholders. So as you think about incremental EPS growth from capital deployment, it's something we've been able to demonstrate over the last few years. And then finally, as you think about our markets, they should be improving. So if you think about the next 5 years, it should be better than the last 5 years. So we think we are primed for accelerated growth, both from market as well as secular trends. We'll talk a lot about electronics, probably during the Q&A. It's important for our business. We're able to drive accelerated growth by taking advantage of our strong electronics portfolio. Down below, we got some charts on our mix of business, mostly in Americas business. 80% of our revenue is in the Americas. I'll break that down by market in a few slides and then 20% is in our international segment or outside the Americas. And then as a business, 1/4 of our business is electronics, including software and services, we're over 30% now. And our mechanical, you see is about 2/3 of our product offering. We're much more than just the lock, right? You think of us as a lock, but it's everything you hang around the door. And when there's complexity in the building, that's where we win. As I mentioned, we serve -- our core market is our nonresidential business in the Americas, right? Think of school safety, you think of Allegion. We have a unique demand generation model where we create demand by influencing the architect in the design phase and the institutional and end users and that we pull product through our channel. And it's a business model that only one other player in the industry really has the strength that we have in North America. And a key element to our growth is both that core strength, but as well as the improving electronics in nonres, res and international. It's across the board. Electronics is a big growth driver. Moving over residential, much smaller for us. You can think of us our Schlage lock business and a growth driver for us there, electronics again. And then finally, international. International is a great improvement story for us. If I met you in 2013 when we were spinning out and the company was created, this business had 0 operating margin. We are now at industry standard at mid-teens and a much healthier business model and portfolio than we were 1.5 decades ago. Then finally, end markets, right? When I speak to you all, we understand how important it is. I'll summarized by saying nonresidential, 80-20. So 80% of our business is in the nonresidential space. Of that 50% to 60% is institutional end markets. You could think of that as a very resilient, stable market, not much market fluctuation when you think about institutional markets. It's why when you see Allegion, even in bad markets over the last few years, so if you think about '23, '22, '21, very poor Dodge growth data and we still were able to grow our business. Commercial markets, this is about 30% to 35% in there. That is commercial office, industrial, data centers. For us, data centers is very small, but growing nicely. And then finally, multifamily for Allegion, we put multifamily in our nonres business. Most of the products there are the same nonresidential applications. So you'll see that's where we included in our results. So as you walk away, think of us nonresi institutional stable business. So with that, we're going to -- I'm going to come back for Q&A.

This is a great intro for everybody, and let's dive into Q&A. And let's talk about the company transformation and cultural leadership. And I think Allegion has evolved from traditional mechanical companies, a hardware company to a more platform-based innovation-driven leader in security and access solutions. What have been the most important cultural or organizational changes driving this transformation, Mike?

Yes. As I mentioned earlier, if you've been listening to Allegion, we talk about electronics and our industry is kind of steadily evolving from a historically mechanical-only business to an electromechanical business as well. It's now over 30% of the portfolio. And it's really been a net positive for us because it grows faster than the traditional mechanical. So if you listen to us on our earnings calls, we believe in our Investor Day, we can grow this business at a high single-digit to low double-digit clip. And if you look over history, we've been able to demonstrate that. So we're able to get accelerated growth from this electronics trend. And I think the positive that we also see there is products get more complex, the market leaders do better. So electronics is a net plus for the market leaders like Allegion, and we're able to capitalize on this industry trend to drive that accelerated growth.

If you could touch on the -- for technological or engineering perspective, how the people actually in your employee bases transforming that, actually driving those from the manufacturing standpoint and design perspective? And could you talk about that?

Yes, sure. When we first started off, traditional mechanical, we had to change our engineering base, right? So now that we have more electronic engineers than mechanical, electronic and software. We also have done an effort to platform our electronics offering. So go back 10, 12 years ago, we probably offered point solutions. Today, when we come out with offerings, these are platform solutions, really accelerates our speed to market for future generations and allows us to innovate more quickly and more efficiently. So this is an improvement that we've had over the last, I'd say, 4 or 5 years and we've demonstrated this. If you come to our technology center in Indianapolis, we can show you, but we highlighted this at our Investor Day a few years ago where this platforming has really resulted in an acceleration of the pace of new product development. And if you listen to our earnings calls, we always highlight some of the new products that we released to market. So think of it as a way for us to introduce more products quicker and more cost effectively.

And then if you could talk about the topical and thematic and one of your purposes of the safety. So how you actually describe yourself in terms of the safety culture and also what's going on in the market in terms of the safety as a megatrend?

Yes. So safety for us is a core value. If you think of our values, Be Safe, Be Healthy, is the top value that we have, right? So it's one of our great [indiscernible]. It's in everything that we do when we operate, whether on the plant floor, it's so important for us to keep our employees safe. But even out in the marketplace, right, school safety. For us, it's paramount. We think of these things, right? If there's an event, right, our goal is to keep children safe. And we have examples -- John, our CEO, as an example of a cylinder that a channel partner or a customer gave to us of a cylinder, which had a bullet hole in it. And the channel partner handed it to him and said, "Hey, and you see the hole in it." This cylinder held and those children were safe and went home that day. I give it as an example because this is core to who we are. We think about this every day. And this kind of influences everything we do as we operate as a company.

And then diving into our end markets, the U.S. nonresidential, especially starting from institutional business. Could you talk about the customer new builds and replacement cycles? And so what's driving the next 3 to 5 years horizon for your revenue and your competitive landscape as well?

Yes. So I'll just quickly talk to end markets. I showed a little in the prepared remarks. For our business, and it wasn't on the slide, think of our business as being half aftermarket, right, not subject to market trends, right? From a new build perspective, half the business not really impacted. Stuff breaks, in our industry, you're going to replace it like-for-like. And for Allegion, where we're strongest is when the premium products in that institutional vertical, the school, the health care, the higher ed building, what we create is an end user standard. We create a standard for that campus so that any aftermarket is our product as well as any new construction. If you're going to put a new engineering building on an Allegion campus, it's going to be our products. It's a way of keeping ourselves very sticky with our customers and our end users. And it really provides a lot of the stability we talk about in our business. Now one of the efforts we've done to improve or accelerate growth is we put a concentrated effort at accelerating aftermarket growth. And one of the things we've done is come out with a new offering of mid-price point products. We highlighted that at our last earnings call, the Von Duprin, LCN and Schlage mid-price offering, it's a way for us as a premium player in the space and a market leader to do even better, right, and to accelerate growth into that mid-price point. So it's a way for us to further diversify the revenue base away from just new build. And the thing about Allegion is don't think of us as cyclical with respect to, let's say, the Dodge data. Think of us as a kind of resilient business with half aftermarket and a sticky end user base.

If it comes to the 50% aftermarket and resilient, what would you say in terms of the market shares, given the customers' stickiness and aftermarket sales. If you look at the 10 years ago, but how is the dynamics evolving in your industry?

Yes. So if you go back to our spin in 2014 when we were created, we really didn't do as well there as we should have. We didn't get our fair share. And we've put efforts over the last decade to continue to improve that aftermarket presence. And you've seen it in our growth, right? We have industry-leading growth in the in the marketplace in North America. Part of that is you just get a little more tailwind from aftermarket. This is something that I don't think will ever be done we have room to go as far as like improving in the aftermarket. In the institutional, we have that pretty locked down. But as we think about commercial office and others, we'll continue to just try to get a little better there. So I view it as an opportunity, significant improvement over the last decade, but still more opportunity for growth.

And if you -- when you talk about the electronics, the evolutions, what kind of customer base institutional commercial or multifamily. Would you see a bit more high introductions, adaptations of those kind of moves, please?

If you look at the industry, and I'll talk to -- first, I'll start with nonresidential. You'll see the perimeter has been electrified for a while. But if you think about the interior, whether that's a multifamily unit or an interior door at a campus, a college campus, just over the last decade, you see an acceleration of those doors being electrified. Those are great opportunities for us. If you look at our last Investor Day, we highlighted a couple of examples. But multifamily traditionally is an old key. And when someone leaves, you got to pay for a locksmith to come and change that cylinder. We can create solutions for our customers where all you have to do is remove the access. That's operating savings for the facility owner and manager. That's why we're seeing an acceleration in growth in electronics. When you think of the interior there in multifamily, in the case of higher ed, it's the same dynamic, right? Traditionally, you would have a key to get into your dorm room. More and more, that will be a credential, especially mobile credentials. Our first evolution of electronic locks, we didn't really -- there was no such thing as digital credentials or mobile credentials. Today, more and more, that's going to be a driver of electronics, where your credential will be on your phone, not necessarily a key fob, especially in higher ed, in multifamily. So that is also an accelerator of growth for us in electronics for both the industry and Allegion.

If you could walk us through the introduction rate for like the vertical like multifamily have more electronics versus mechanicals or nonresidential versus residentials?

Yes. Residential, think of electronics is just the perimeter to the home, right? If you live in a single-family home, a whole lot of mechanical locks in the interior, that's going to remain a mechanical solution. In the perimeter, it is becoming more electrified. And for us, one of the things about our electronic locks is you could see the average selling price being double and the useful life being shorter, right? And that's a net plus for us, right? So you can have a home where traditionally our parents may have lived in the same house for 30, 40 years, never changed the locks, right? If you have electronics locks, it's going to cost twice to -- when you make the initial purchase. There's a shorter replacement cycle because obviously, electronic componentry doesn't have as long a useful life. But there's also a net benefit where technology will improve over time such that you will take off a working lock and put a new generational lock. I'll give you an example, my home. My first electronic lock did not have WiFi capability. So when the new solution came out, great ad to have WiFi capabilities, so I put a new lock on the door. In the case of non-res, which is the lion's share of our business, right, a lion's share of our business is nonresidential, yet that same dynamic of a replacement cycle with being shorter and the ASP being double. There, the technology could be a digital credential. Our first adopters of electronic locks in higher ed didn't have mobile credential capability because it didn't exist. So we're seeing some of those early customers retrofitting to the capability of having a mobile credential. It makes sense in higher ed, if you think about students, they have to get access to 10,000, 20,000 dorm rooms a year, right? So much more efficient for them to do that via an electronic solution, a mobile credential than the traditional mechanical when someone like myself was in college.

Mike, could you talk about the -- how do you accelerate the electronics versus the mechanical hardware, the movements by organic versus the M&A, like for Allegion?

From an organic growth perspective, think of electronics as that high single digit to low double-digit grower for us, and we've been able to demonstrate that over time. Our industry is -- it's slower moving on adoption. And what I mean by that, if you think about LED lighting, LED lighting, there was massive adoption in a short window. For our industry, think of it as a steady tailwind, right? Steady tailwind to growth where you're not going to grow 20%, 30%, 40% a year organically in electronics, but it takes a long time to retrofit the old massive installed base over time. As a result, we think we can grow it at that high single, low double-digit clip, and mechanical doesn't grow at that level, right? And so it's not going to grow as well as electronics. Electronics is our real accelerated growth driver.

And if you could talk about the margin expansions and opportunities? And could you -- and then if we step back and thinking about you create high levels of margins versus the competitors, like what makes you unique? What makes you differentiated for creating margin profile?

It's part of our DNA, right? So when we think about managing margins, it's something we do extremely well. And part of it is how we manufacture our products. If you go to our Indianapolis facility where we make our exit device, we service the North American market via this one plant that is a highly configured complex offering. What do I mean by that? We can offer millions of SKUs to our customers out of that plant. It's how we're enabled to maintain the margins that we do. We're extremely efficient, coupled with the premium brand and high-quality products that we have in our demand generation activities, which are tops in the industry as well. But from a margin perspective, it's a combination of the great front end where we create demand in the design phase with the architect, we influence the end user and we pull the product through the channel as well as a manufacturing excellence that allows us to really serve our customers very efficiently.

And then if you could talk about the pricing strategies to expand the margins versus inflation, especially in 2025 and also in 2026. How would you manage those kind of inflation by pricing strategy?

As a company, if you listen to our earnings calls, you'll hear us talk about pricing and productivity covers inflation and investment. It is core to us. We talk to every quarter. It's how we think about managing the inputs. If there's inflation, we have to pass that along to pricing in the form of pricing. And for us, how we're able to do it is that great front end that we have in the nonresidential business where we're able to command that pricing. In our industry, we're able to compete on value, not price. It's not an industry where it's a race to the bottom. Everyone prices for the value that they create in the marketplace. Being the premium player, we have as strong as anyone ability to get that pricing and it's part of our DNA. The other half, which is -- maybe we don't talk as much about but is really important, we have to drive productivity to fund our investments as part of what we do and look for us to continue to invest in automation in order to do that as well as drive an efficient operation. It's a combination of both. It's that pricing and productivity that helps provide some of the tailwinds to margins. If you look at '25, we were subject to significant increases in inflation because of tariffs. And as you saw, we were able to manage that and have net positive dollar coming from pricing and productivity in excess of the inflation and investment. If you look at our history, we had a slide in our earnings deck a couple of year ends ago, where we showed that trend over a 5-year period. And what you see if you go to that slide, is a history of being able to demonstrate that pricing excellence and productivity excellence to drive margin expansion.

Mike, if I could double-click on productivities by automation, platforming and digitalization, could you give us some examples like for -- like having those kind of impact?

Sure. In the case of platforming, I talked about that earlier. And for us, it's not just electronics. We're also doing it in our mechanical portfolio. It allows us to drive efficiencies, speed in the case of new product introduction, so you get some leverage on the R&D spend. But even operationally as you operate your factory, if we can eliminate some of the internal complexity, allows us to run more efficiency. So platforming has been a leg of that. Automation is another leg of that. As a company, we've been increasing our level of CapEx in our plants to drive productivity. We are now -- we see a step-up since I became CFO to now, it's about double the dollars per year. Think of it as a 2.5% of sales CapEx. The key thing for us is we're spending the capital, but you're seeing the productivity and you're seeing the margins, right? And so investing in automation, both in the plant, but even in the SG&A space, makes us more efficient and look for us to continue to do that.

And let's talk about residential market in the U.S. And how do you see demand in 2026 plus your initiatives to grow for the next couple of years as a strategy?

For us on residential, we've been pretty consistent with our messaging that residential has been soft. So in 2026, during our outlook that we provided, let's say, a month ago on our earnings call, we said down slightly, right? In '25, we were down low to mid-single digits. So it's been a softer market for us. Anyone who follows resi knows that's in anyone who sells into the residential home. For us, one of the opportunities for growth we've been taking advantage of is electronics. And our electronics in residential has also grown faster than mechanical, not at the high single-digit rate we were talking of, but certainly more than the mechanical. And so it's an opportunity for us to either mitigate the weaker market or to drive accelerated growth depending on how you use the terminology. But it is a net plus for us. In our third quarter, we highlighted this in our earnings call, where we had a new product introduction, and you see the growth that can come from innovation. So look for us to continue to innovate in electronic locking across the portfolio. But inclusive of that, it would be the residential business where it does allow us to get some secular growth opportunity.

And then so when you talk about innovations, when it comes to AI, could you talk about the opportunities and risk of AI when it comes to your operational excellence of the business model?

If you think about operations, it's a way for us to drive efficiency, a way for us to drive productivity. It is a -- it's in the early stages. We're all trying to figure out how to leverage it better and we're going to be able to leverage that better over time. But one of the ways we've been able to initial quick win is we've been able to automate our order entry process with our customers to be more efficient in how they get us their orders, eliminating the need for as much manual intervention. So it's a way that 5 years ago, we were less efficient than we are today. I think -- when I think about I see it as an opportunity for us, especially on the cost side. As far as threats, I really don't see a big threat from AI. We get asked by investors all the time about, is AI going to disrupt our business? And I'll just go back to that complexity of the nonresidential business where we create demand by influencing the architect, influencing the end user, creating that standard and having an installed base on a campus for decades up to centuries as well as an elaborate distribution network where we have relationships for decades and longer. All of this combined with offering a broad set of products because if you can't provide all elements to the offering of a building, you're going to be less successful. That is a case where there's only a couple of players in North America who could really do this at scale, 2 to 3. So therefore, I think it's an opportunity as technology over time advances, it tends to be a plus for the largest players in our space.

And then could you talk about the risk of electronics evolutions when it comes to cyber securities as well as the data securities and how would you tackle with those kind of risk from Allegion?

Obviously, for electronics, this is something that the mechanical we never had to worry about, right? So it's something we put considerable time and effort to ensure we have the most secure and safe products and the leading products in the industry. Also with Allegion, and it's important to understand where we do and don't play, we are not playing in the enterprise access solutions space. Those would be other companies where we partner with them. And that is not just Allegion. Our whole industry will partner with enterprise access solutions or access control solutions. And so as a result, when you think of Allegion, don't think of us as playing that enterprise access control, think of us as our partner of choice strategy where we partner with these players. But ensuring that we have the most safe, secure products is top of mind for us, whether that's an electronic solution or a mechanical solution.

Mike, if you could talk about the international business in terms of the growth opportunities plus the margin expansion opportunity, please?

International, as I mentioned, when we started Allegion, this journey in 2014, 0 operating margin, right? We were a breakeven business. And when I was in Investor Relations, 2016 to '19, I'd get asked all the time, why don't you guys just get out? And what we were able to demonstrate is we've been able to get to industry-leading -- industry-standard margins. So our margins in international are up there with the peak players in the space, right? Considerable improvement over time. A couple of ways we've done that is operational excellence, bringing some of the capabilities and strengths we have in the Americas and leveraging that internationally. We've also spent some effort on the portfolio, both on the addition side, where we've added great electronics businesses that drive faster growth and more profitability. And on the sales side, where we've divested some underperforming assets. Think of the Middle East, Korea, China, et cetera. So I think it's a combination of both where if you listen to our earnings calls, we'll say this all the time. It is a much healthier portfolio of products today than 15 years ago. I think it positions us, so if we think about the next decade, we're going to be in a much better place than we were 10 years ago, right? And so that's something we're quite proud of the improvement in the International segment as a company.

And capital allocation, M&A. Mike, could you talk about the -- with the strong balance sheet, robust cash generation, how do you prioritize between organic investment, targeted M&A, share repurchase, dividends?

Yes. We talked about this a bunch at our Investor Day last May. I recommend you all listen to it. We probably spent a good 15, 20 minutes on it. I would say it starts with organic growth. Look for us to continue to invest in R&D to drive the right products. That is core to us. We'll continue to do that, right? We help pay for that by driving productivity, but we're always going to continue to invest in R&D. And we've increased our R&D rate. From 2021, the rate then to today, 1.5x. What do I mean by that? The $1 spent today are 1.5x the dollar spent in '21. So organic growth is key. Then with the remaining free cash flow because organic investments, R&D, that's within free cash flow. Historically, think of us as about 50% of our free cash flow will go to M&A. Dividends payout ratio is about 30%. The remaining 20%, that's where you'll see a share buyback or M&A. We call it the swing factor. Historically, if you look at the historics in that Investor Day deck, you'll see that equates to what share buyback is. You could think of it over time. Last year, obviously, more M&A. So it's a little more last year. But over time, think of it as roughly half the cash flow will go to -- free cash flow will go to acquisitions, 30% dividend and then we also have the buyback.

I think the time is up. So I'll wrap it up. Thank you very much, Mike, and thank you for everyone for joining today.

Thank you.