Lincoln Electric Holdings, Inc. (LECO) Earnings Call Transcript & Summary

Well, thanks, everyone. I think we're jumping right into it. I know some sessions ran long last time, unfortunately, I'm to blame for at least one of those. So thank you, everyone, for joining us here. My name is Adam Seiden, I'm the U.S. Machinery and Construction Analyst at Barclays. Joining us today for this session is Lincoln Electric. From Lincoln is CFO, Vince Petrella, and we also have from the IR team, Amanda Butler on the audience. So the format of this session, like many of the other ones, it's going to be a fireside chat between Vince and I. We'll certainly leave some time towards the end of the session, if there's folks in the audience that have questions themselves. What we'll also do is we'll do an audience response questions. We'll probably do that a bit later in the session here and then I'll go from there.

So I guess, maybe to start, Vince, if there's just maybe a very quick overview on Lincoln Electric, in essence, what you guys do for those that are less familiar in the audience, and then we could jump in.

All right. So Lincoln Electric, a company that's been around now for 125 years. We're the leader in our space. It's the arc welding and cutting space. We're a global firm. We did about $3 billion of turnover in 2019. Our operating profit margins came in about 13%. We had a year where our volumes were down, finishing the year, mid-single digits. We're experiencing some compression in some of our largest markets currently in automotive and heavy equipment. But our products go just about anywhere, where 2 pieces of metal are being put together. We also have a cutting part of our business. So metals need to be cut before they're joined. The 2 biggest lines of our business are the equipment or the power source and also the consumables or the filler metals. And so we have a solutions-based approach. We have deep knowledge in metallurgical science and joining of metals. And so we're one of the few players in the industry that can offer a complete solution to our customers. We go through 2 basic channels, direct to end users and also the distribution channel. We sell about roughly 40% through end use directly to big OEMS. And then distribution is roughly 60%, 65% of our business. And that's a rough -- some sketch of Lincoln Electric in the arc welding and cutting industry.

Well, that was very good.

Very efficient.

Very, very efficient. So maybe let's -- diving right into it. And one of the things that we're talking about with a lot of our industrial companies is the line of sight towards potentially a turn in the market. It's certainly been -- as you said, there's been some challenges. There's been decelerating trends, if not negative, even growth for some companies over the last year actually or 2. So for yourself, we -- none of us have a crystal ball, but I would love if you could look into your crystal ball and see is the bottom in sight? And then what does that mean for volumes as we pace through 2020?

Right. So the way we like to think about our markets are in 2 dimensions. One, we think about our markets from a geographic perspective, and then we think about our markets, from an end market sector perspective. So starting with end market sectors, 2 of our more important end market sectors are automotive and heavy industries, heavy fabrication. So the folks that make things like heavy equipment, mining equipment, construction equipment, shipbuilding, things like that. And those 2 markets are roughly 35%, 40% of our total end markets. And those 2 markets have been relatively soft during the course of 2019 and have remained soft moving into 2020. A market that is fairly large for us is the energy, oil and gas market. That market has been relatively stable in the fourth quarter of 2019 and has moved into 2020 roughly flat to the prior year. Geographically, certainly, North America and the Americas has been the standout during the course of 2019. Our weaker markets have been internationally in Europe and in Asia. China has been softer in the course of most of 2019. Again, biggest markets in China, even disproportionately more important to us than the Americas and globally are automotive and heavy industries. And those 2 areas have continued to be soft into the first quarter. So January of 2020 has been -- was operating at basically the same year-over-year run rates as the fourth quarter exiting December. And that's down volumes, mid-single digits. I would tell you that the Americas is slightly better than that. And international is slightly worse than that. So the Americas continues to show a little bit more resilience than what we've seen in other parts of the world. It's probably worth muddying up the outlook with what's been discussed, I'm sure, in all the meetings today, and that's coronavirus.

Coronavirus.

Yes. You read my mind. Didn't you? And so I really view that as uncertainty. At Lincoln Electric, we have 5 facilities in China. Most of those facilities have been shut down since the Chinese New Year. We have a couple of those facilities that are operating on a limited schedule right now. But my view of first quarter and first half of the year in China is that we have $160 million, $170 million book of business. It's mid-single-digit to high single-digit operating profit, profitable. I think first quarter we'll likely record losses in China because of the lack of production and covering our fixed overheads. I think, Adam, remains to be seen what the second quarter looks like. But certainly, the longer this goes on, where we're not operating. And China, Inc. is not operating at its normal capacity levels. It becomes more likely that there will be a knock-on effect to the worldwide logistics and supply chain channels. So I'm a little concerned over how long this disruption will occur and the knock-on effects that it might have on our business. Having said that, I believe that the first half is going to be challenging for Lincoln and many other industrials as we work our way through that uncertainty, but a little bit more optimistic about the second half of the year, knowing that this industrial compression has now gone on -- will have gone on for more than 6 quarters. The average industrial compression is roughly 6 quarters. Hopefully, second half of the year, some of these headwinds will convert into tailwinds, including our automation business that has been soft during the course of '19, and it represents roughly 15% of our total book of business. We view automation as part of our portfolio that will afford us a higher long-term growth opportunity. We believe that growth opportunity should get back on track as automotive and heavy industries turn back to a stabilization in a growth mode. So I'm looking more to the second half, concerned about the first half being challenged by those headwinds, including the coronavirus.

Got it. On just -- you've run coronavirus, of course. So when you think about the supply chain, I think you said there's still a lot of uncertainty how that all pans out. Is there a way to think about like what you currently have in stock today where you're sitting? So if there are some disruptions, like how big of an impact that could be or...

Yes, so my view is just understanding supply chains and the length of supply chains from Asia to other parts of the world, understanding now that we're in our third, fourth week of shutdown, including the Chinese New Year, which is obviously planned for. It's my view that another 2, 3 weeks of this, we will start to see a broader impact on global supply chains that inventories are clearly being worked down to the extent that we have inventory in the supply chains. And I think if we're not back up to 100% type of pre-Chinese New Year, coronavirus shutdowns, we'll start to see a more pronounced impact on global manufacturing and supply chain. So I'm hopeful that as the incidence of the virus starts to decline, that we can continue to see manufacturing facilities ramp up in China and avoid the greater and more pronounced impact of a prolonged shutdown.

So when you think into that second half, and you mentioned a bunch of tailwinds that could get you there, like what sort of leading indicators would you look at within the business? Is there even -- if you think of the 2 sides of your business, consumables equipment, is there one that tends to react first when things are moving?

So we look very closely at ISM or the Purchasing Manager Indices worldwide. We look at industrial production, but it's interesting that we've seen some improvement in European ISM. We do have a lag in our business, Adam, that you know that could take 4 to 6 months for us to respond. So I'm not getting too excited for the first quarter and maybe even the second quarter. If we see a sustainable improvement in European Purchasing Indices, we should start to see that come through the latter part of the second quarter and into the third quarter. So we'll continue to watch that. It's pretty early on. It's still below 50. We have had a tick up now for, I believe, a couple of months, but we'll be watching that as well as industrial production. And maybe the last when we look at our commodity prices and oil prices. So oil prices, commodity prices rising, tend to have some positive impact on our business on a lag basis as well.

Got it. So there's -- clearly, you guys are in a cyclical industry. I cover cyclical industries, and Lincoln's been through these cycles before, and the seen volumes go up, and in this case down. So what's differentiated this cycle for Lincoln versus some of the prior ones? And I only say that because the flow-through rates have been a little bit different over the last couple of quarters here.

I think -- so the biggest differences are on a product line basis, we're more heavily exposed to automation. Automation, again, is about $450 million of our $3 billion business. It tends to be a more cyclical business on the downside. We believe it has a higher growth trajectory on the upside, high single-digit type of long-term growth opportunities there. So on the downside, we're seeing that more pronounced impact. But we are also seeing unique to Lincoln, we believe, a stronger performance in the equipment side of our business. So our -- we're known as innovators in our industry. We have a very strong R&D and product development pipeline. We've actually held up better than what would be expected in this type of environment, with a flattish equipment sales performance in the fourth quarter compared to our consumable filler metals being down high single digits. And that's unusual in studying our performance over many cycles back to the 1970s. When you have consumables down high single digits, the expectation should be that equipment would be down mid-teens or almost double. And we think that some of our competitors around the world are experiencing that based on anecdotal conversations that we've had with the competitive marketplace, and we believe that some of our larger competitors are having declines on their equipment portfolio. And that's purely because of Lincoln's performance and not necessarily anything we believe that's different in the marketplace.

Got it. So on pricing, we've gone through an interesting period here where beyond just normal course pricing, there were certainly some surcharges that were put through by the company and a lot of peers across industrials, so the price comps have been challenging as those roll off. But could you talk a little bit about the forward trajectory on price in that volume backdrop that you laid out for us earlier. And just more generally, as far as your pricing philosophy over the course of the year?

All right. So we did put surcharges on last year because of the 25% steel tariffs that went in on steel in the U.S. We're able to roll those back the early part of the third quarter of 2019. So they will -- those surcharges will anniversary themselves in the third quarter. But you will see because we peel those off, and particularly in the Americas, there's negative year-over-year pricing impact. I believe that once we get to the second half of the year, as long as we're in this type of a softer environment with mid-single-digit sort of declines exiting the first half, that we'll probably have some very modest price increases ex those steel tariff pricing adjustments that were on our book of business in the prior year. So I think we'll probably have tens of basis points of price by putting through some modest equipment pricing increases. And then we'll have to look and see what the inflationary impact on the consumable side of our business is and judge whether or not we need price increases there. But I think second half of the year, I'm looking at very modest pricing improvement in the face of a softer type of environment. Lincoln's performance and price management, I think, has been very good through cycles. We tend to move pricing very quickly when we see inflation, or we see tight supply markets. And historically, if you look at our performance, we're pretty good at matching increased input costs with price increases and then hanging on to those increases as long as possible through the cycle. So our price/cost management, I think, has been a bright spot for the company through cycles.

Excellent. Maybe we'll -- we're about the halfway mark here. So maybe we'll move to the audience response questions. While those are pulling up. So on everybody's table here, there's a Blackberry-looking device. We would love for your participation. Do you currently own this stock? Yes, overweight; yes, market weight; yes, underweight; or four, no. [Voting]

I wonder what your answer is. No. All right. Question number two, what is your general bias towards the stock right now? Positive, negative or neutral. [Voting]

Okay. Question number three. In your opinion, through-cycle EPS growth for Lincoln Electric will be above peers, in line with peers or below peers? [Voting]

Okay. Question number four. In your opinion, what should Lincoln Electric do with excess cash? Bolt-on M&A, larger M&A, share repos, dividends, pay down or internal investment? [Voting]

While that's going. Certainly, you guys have had quite a nice track record of doing a little bit of everything.

We have. I think our capital allocation program is very well balanced. I'll tell you, even -- that's very interesting. It wasn't going to be my answer, but yes.