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

Good morning, everyone. This is Nathan Jones from Stifel. We're here with Lincoln Electric this morning and very glad to have Chris Mapes, CEO; and Gabe Bruno, our CFO with us, along with Amanda from Investor Relations.

I'm just going to jump straight into questions here. [Operator Instructions] So Lincoln was an early reporter within the earnings with first quarter earnings call before the end of April. And where you've seen very steep declines in sales and order trends, you were talking about down in the low 40s with a large number of customer closures there. Can you talk about how those trends ended up in April? And how, if at all, they improved in May?

Yes, Nathan, Chris Mapes, and thank you for having us at the conference today. And again, we hope all the individuals on the call today are -- and their families are safe. So as we want to provide an update here at the conference on the demand trends that we're seeing within the business, as you said, we were early in stating in our April call that our business was down in that low 40% range. And we also stated that we thought that we believe that would be the trough for the business, and that would be the troughing, and we expected to see improvements as we were migrating through the rest of Q2 as well as through the rest of 2020. It's good that we have seen that improvement. May, we saw a sequential improvement in May as the order rates declines narrowed. We started to see some of those economies reopen, and that was really in the down in the low 30% rate, and they've -- and we were happy to see that level of improvement as we were moving through May. As you would expect, we've seen also some improvement as we've had just a few days here in early June. And really, quarter-to-date, we are down in that low 30% range for the quarter. So a little bit more favorable and seen some improvement in June from May, but quarter-to-date in that low 30% range. If you think about Lincoln Electric and during the Great Recession, our volumes were in that low 30% rate. We were able to achieve decrementals in the low 30% range, and we're still targeting to try to achieve that level of performance as we're migrating through this portion of the cycle.

That's a helpful update. I mean I think as economies continue to open further, it's probably reasonable for us to expect that June is going to be better than May, that's your expectation?

Although, again, only a handful of days, June is trending favorable to May. So -- and you would expect that if we continue to see the trending of the data that we've experienced so far in Q2 that we would see that improvement. Although, Nathan, I will share that there's certainly a couple of the segments where the clarity around the rate of that reopening and building of those segments back is still a little unclear. Certainly, automotive still has some of its challenges relative to that clarity, heavy industries. And then when we were together in April and talked about the oil and gas market, oil and gas had a different level of challenge. It had a supply challenge as well as a demand problem and the demand problem partially was from the pandemic. But we've seen a pretty steep recovery in the oil and gas market as it relates to crude oil index pricing. And certainly, at this point, just unclear as to what that means to the investment or how long that particular cycle will weigh on that segment.

Clearly, when you guys reported in April, it was the peak of the shutdowns and giving any kind of outlook for how you expected the recovery to progress was next to impossible at that time. If I look at -- if we look past the second quarter and into the back half of the year and beyond, with nearly a couple of months under your belt since then, do you have any better visibility into what the slope of the recovery might look like in the second half of the year? And any expectations that you could give us on that?

Well, I would tell you that I think we feel more comfortable in talking about it today than we did in April. But that being said, there's still certainly a handful of variables that could challenge how that materializes as we're moving through the rest of 2020. Certainly, whether there had to be further shutdowns or a return of some of the challenges associated with the pandemic, which could impact the start-up of some of those economies, is a large variable. On the positive side, we've continued to see improvements in the economy in China. And if that could be replicated across these broad markets as we're moving through the rest of the year, then that would be a favorable. I like the fact that the trending of the business has been favorable from a demand perspective. Again, April, May and June, has shown improvement and quarter-to-date in the low 30% down for the business, but trending favorably. So I like the trend data. I like what we've seen in our Asian businesses and our China business, specifically. I'm still concerned about whether there will be challenges associated with reopening some of these economies. And then I'd certainly like to see better clarity certainly in the automotive businesses globally, which have both a startup challenge as well as an understanding of how the consumer reacts in the marketplace in the back half of the year. And then we'd like to see how the oil and gas market and, certainly, the heavy industry markets are performing as we're moving through the rest of Q2 and through the rest of 2020.

Yes. I think -- and you hit on a few of the questions that I wanted to ask about maybe focusing on some of the end markets here that do potentially have some additional challenges. The first one is automotive. We've started to see those business at least reopen, but probably not at a high level of activity as those guys start to figure out what the demand picture looks like, what they need to produce and those kinds of things. I think the unemployment level in the U.S. particularly could see car sales take longer to recover, could see lower spending on new equipment and maybe on automation. Can you talk about what customers are telling you on their spending plans, if at all? And what expectations do you have for that market in the medium term?

Well, I think automotive, there is actually a favorable side to the automotive discussion, which is, at this point in the cycle and the recovery that we've been making in April and May, quarter-to-date in June, we've not seen automotive have the level of recovery as the other segments. So that should be something that's in front of us. So that's a favorable element of the data. The improvements that we're expecting to see in automotive should be in front of us. Although, Nathan, I'll share with you that the conversations and the data coming out of our automotive customer conversations at this point really are still centered on their strategies around starting back up and have not really migrated towards their perspective of the longer-term demand profiles for the year or what they believe their demand profiles are going to look like. So I'm happy that at this point, we are now entering into those conversations around their start-up. We have many of our customers that have started up, although many times you might read that a customer started up a particular facility, but they're only operating one shift than prior they might have been running 2 shifts or 3 shifts. So that start-up in the automotive segment in our conversations with customers has been staggered, has been pushed out. But we certainly expect to see that as we're migrating through the rest of Q2 and into Q3, which certainly will be a favorable element as we talk about our demand profile migrating through the rest of the year.

Helps to sequentially improve, I guess, as we go along as they get more back to business. Oil and gas is another one that I think might have some more structural challenges here. We're going to -- the economies are going to recover, but we're still likely to have lower global economic activity. And you might say a structurally oversupplied market to go along with that as well as an inventory glut that we have to work through. Can you talk about what customers are telling you in oil and gas markets and what your medium-term outlook would be for that market?

Well, the challenges you identified, Nathan, are absolutely the challenges that people are talking about. But prior to the pandemic, there was an oversupply concern relative to the broad oil and gas marketplace. And those issues have to be migrated through those markets. And we need to see that migrate closer towards a level of equilibrium before we'll see more favorability in the oil and gas market longer term. Although, certainly, the recovery in crude oil pricing, when we were providing our update in April, that was a very challenged window relative to crude oil pricing, and they've seen a recovery to near $40 a barrel. And certainly here in the U.S., we're hearing that at those public prices, producer prices, we should see some of the fracking assets actually reengage here in the U.S., which would be a positive. So I think that industry is continuing to work through some of those. I will tell you that some of the areas of the world, we're still seeing some investment. We have some offshore investments that we've seen, some orders that have come through Southeast Asia, which have been positive, but it has been very sporadic. Historically, when we've seen oil and gas markets have these types of challenges, it generally takes 4 to 6 quarters for that cycle to kind of materialize. Now this was a very sharp decline. We'll just have to see exactly how we see that materialize here over the next few quarters.

Okay. That's helpful. I think it's probably parts of the construction market as well that are likely to see depressed activity for some time with excess capacity in markets like retail, lodging, restaurants, et cetera, as we maintain social distancing for an indeterminate period of time at the moment and as working virtually for some folks becomes more permanent. Maybe that leads to lower construction machinery production then we would otherwise have seen, which would have a negative impact on the medium-term outlook. Can you talk about how you're thinking about that market? And if you see any offsets in the construction markets that might help out?

Well, for Lincoln Electric, the only potential offset that I see is that we have some unique solutions, especially in the structural steel segment that, quite frankly, have allowed us to probably participate in a larger portion of the market than maybe what the overall market demand has provided, Nathan. I will tell you that when I think of the various segments that we're participating in, this particular construction market segment is concerning to me. And it's because of some of the dynamics that you mentioned and just the uncertainty relative to what types of investments we're going to see on down the line as we migrate through the rest of this year and into 2021 that could impact the construction industry. I think that this may be one of those segments that we look back on that was most negatively impacted by the pandemic recession. And we are believing that it will be a challenged area for us as we're migrating through the rest of the year. Unlike general fabrication, even unlike automotive, that we believe we'll be able to get our arms around and see what that demand profile looks like. I think the construction market could be very challenged. The other element associated with portion of that construction market, Nathan, also turns in to the seasonality associated with that. Because of when the pandemic was hitting in various areas around the world, you are going to lose 60, 90 days of that construction window that maybe otherwise businesses weren't able to maybe get as much of that work done as they would have liked. So I think that will certainly be a headwind as we look at this data for 2020, and it's just a little unclear as to this particular segment's ability to have the level of investment they'll need as they're migrating through the rest of the year. One of the more challenged segments, I think we'll have at Lincoln Electric in 2020.

That's great color. The last one I wanted to talk about was general fabrication, which is your largest "market." Can you talk about the dynamics in some of the larger pieces of general fabrication and how you're thinking about the progression of that market over the next few quarters?

Well, one of the favorable elements of general fabrication market for Lincoln Electric is it just doesn't have some of the large exposure to any one particular end market. So it is really an aggregation of a host of segments and customers that are in varied businesses. And some of those businesses may be supporting those larger OEM segments, but that diversity provides us a buffer relative to having any one larger segment that would be impacted. We really do think about our general fabrication business as kind of an industrial production or a PMI type of a business inside the company, are we growing faster than industrial production. And I do think that we'll see some of those benefits in general fab. We also were a little stronger in our general fab segment leading into this recession. And so we're hoping to keep that momentum that we had prior to that and maybe migrate through a little bit more favorably as the recovery begins to broaden. I also believe that some of those smaller businesses, and they tend to be smaller businesses that are in our general fabrication segment, may have an ability to get up and operating more quickly, might not have some of the challenges of the larger enterprises and larger workforce challenges associated with managing through the pandemic and seeing the demand cycle. So general fab should be, I believe, one of those market segments for us that I think we'll look at this year that will be more favorable.

Okay. Really appreciate all the transparency on the business there. So now getting away a little bit from the short term and talking about something that could become a meaningful driver of growth for Lincoln and where you've invested some money on acquisitions and product development, and that's the additive manufacturing side. I do understand this is a very long-dated initiative, and there will be a cycle of development and testing and acceptance before that business might ramp up to be something meaningful. But can you talk about the investment thesis and how you believe this business can create value for customers?

Yes. And look, I think that when we talk about additive at Lincoln Electric, it really is at the core of the strategy and the way we think of the business because this really is a business that we're incubating. It's a business that has relative technologies that we already had as a core competency around the metallurgy and the software required to accomplish wire-based additive manufacturing. And we're applying those technologies into this new business. And the reason why we're excited about it is because we have those competencies, and then we like this market and the market growth. And today, we believe that's probably about a $2 billion market. It's growing about 20% to 25%. And we think that, that growth is going to continue through the duration of the Higher Standard Strategy, and we really don't see why there would be a ceiling to that growth for a period of time. It's not overly complicated for us to see the value proposition because individuals that might be required to go buy expensive capital or expensive machinery to make larger parts can do that through an additive-base process and not have that infrastructure cost and actually have a speed to market with these components at a much higher rate. So we like the value proposition. We like the business. I'll also tell you that I expect it's going to be one of those catalysts within Lincoln Electric that's going to be much greater for the individuals that are running the company in the next 10 to 15 years than it is in the short-term for us. We are working with customers. We are doing design work. We are making parts, but it's not a material piece of our business today. But we do think it's the right investments that we need to make in an innovative technology in an area where we have expertise that we believe we can have a leadership position in wire-based additive components. So I just like that market space. And we're still going to continue to invest in it. We've been investing in it throughout the cycle even recently and have a dedicated additive facility here in Cleveland, Ohio, where we have cells that are manufacturing these products and like it as a long-term portion of our portfolio.

Yes. I absolutely agree that speed to market in certain industries, there is a massive value creator and could be a massive value creator out of this business. You are going to need some development and acceptance and testing to get this out there. What's your kind of time frame thinking about this? When do you think your additive could be a meaningful contributor to growth for Lincoln?

Well, today, especially with us greenfielding the business, and one of the challenges associated with implementing the strategy, Nathan, because we're one of maybe only a handful of individuals that are actually doing wire-based additive manufacturing. And for those on the call who might not be more familiar with that technology, that's -- that, instead of a powder as a way to make a metal part, we're actually using our wire based technologies, which allows us to generate a level of speed for the deposition of the metal, which is much greater than powder-based applications. But there are only a handful of individuals in the world that are utilizing or trying to utilize that technology today in making parts. And really, we believe, maybe only 1 or 2 that are doing that, that are making large parts like we're targeting. That's important as I talk about the growth rate because we're going to have to drive all that growth organically. There aren't acquisition targets out there that are going to provide us the level of growth vector that we might if we were trying to build that business out more quickly. Because of that, Nathan, I don't really believe it will be a material piece of our revenue base as we continue to build the company, certainly for the next 2 or 3 years. I think it will take us a considerable period of time for the revenue to grow to a point where it's something that we're talking about as being a catalyst to the growth. But if I see us continuing to build that business, and we do it like we do a lot of things at Lincoln, look, we've just got targets, and we're going to continue to build out that structure. We need to get to $10 million. When we get to $10 million, we need to get to $25 million, and there will be investments for us to be able to do that. But I don't see that as a short-term strategy for us as far as driving organic revenue, I really see it as much more of a long-term strategy before it's more material.

Okay. Thanks for that. I would like to get an update on the European business, focused on the integration of Air Liquide and the margin targets you guys have laid out for the International segment when that business was acquired. I think it's fair for me to say that things haven't gone probably as well as you'd hoped with the integration of that business. It wasn't on target to deliver the double-digit margin goals that you targeted in 2020, even before the pandemic hit. Can you talk about the biggest challenges that you've encountered during that integration, where you are in overcoming those problems? And whether you continue to expect to be able to deliver double-digit margins when the volume does return?

Well, Nathan, I think a couple of really key fundamental statements that I need to make sure that we share with our shareholders and potential shareholders. And one is that our target is still to bring that business to double-digit operating margins. And we know we need to build that path and execute on that path to double-digit operating margins. The second comment that I need to make sure that I share with you is that, look, as much as the Air Liquide acquisition did not execute at a level that I would have liked to have seen, there were opportunities there that we probably did not execute on. But that investment has been a very good investment for our shareholders. So that -- the IRR's associated with the Air Liquide investment are in the low teens, much higher than our average cost of capital. If I had the opportunity, I would do the transaction again. So it's brought us some people, some processes, some products that we think are very unique. And at Lincoln Electric, we need to continue to drive the value that we think we can get from those assets and those individuals to get to that margin target. But the investment's been very solid for us. We don't talk about it internally, about an integration project any longer. We should be beyond the integration project. We do talk about what we need to do to continue to make improvements in that business. We certainly had the headwind of some economic challenges in the European market that occurred during that cycle. And then we also had some challenges with the integration from an ERP perspective that impacted our ability to service customers in late '18, early '19, which have been completely resolved. And the data today from a customer service perspective is actually better for the entire enterprise than it was prior to the acquisition of Air Liquide. So we've still got work to do. We certainly need some volume help. We need some improvement from the market. But all of the work that we need to do is not the improvement from the market. Of the structural cost savings that we're driving at Lincoln Electric this year, which have kind of gotten brought into the discussion because of the challenges associated with the recession from the pandemic, much of that was driven in our European business, work that we were continuing to do to make the improvements that we think we need to build that path towards those double-digit margins. We need to continue to execute on those. We need to be prepared and execute on the market growth when the recoveries occur in that broad European market. And then part of that is continuing to drive our solutions. We just launched our new technical center outside of Frankfurt, Germany that was opened last year. We continue to work on shared service models associated with our ability to streamline some of our processes. We have a very detailed path to that, and we need to execute on that portion as we expect to see those markets recover over the next several quarters.

Yes. And I think it's worth noting that Air Liquide had low operating margins when you bought it. You clearly were aware that, that business was "broken" when you've got it and the price that you paid for reflected that. So I don't think it was a poor acquisition. And clearly, with low teens IRR even without getting to your targets, there's certainly a lot of upside there. Maybe we could talk a little bit about capital allocation as the balance sheet is in very good shape. And you have the flexibility to do some things during the downturn or on the other side of it. Lincoln stepped up its repurchase a bit in the first quarter and suspended it going forward. You guys have been a consistent share repurchaser over the last few years, having reduced the share count by just over 20% in the last 5 years. I know share repurchases are getting some slack at the moment, but you've done it while maintaining a strong balance sheet. So I'd like to hear how you're thinking about share repurchases going forward once you're comfortable that the business -- businesses don't need to just hoard cash?

Yes. And look, I think this is where our perspective on capital allocation and our ability to stay to the course on capital allocation has added great value for our shareholders over the long term. The first thing I would say about share repurchases as it relates to 2020, as I think that we were very good stewards of capital with the share repurchases that we made in Q1. When many individuals might have been pausing because of their balance sheet concerns, we were confident in our balance sheet allocation and ability to execute on that. And we did a $110 million of share repurchases in Q1 of this year. In April, we did say that we were going to pause on our share repurchases. But that really wasn't because of any concern over our balance sheet. I feel very confident about our balance sheet and our targets around our balance sheet. We actually stated that we were going to pause our share repurchases because at that time, we were also telling the market that we didn't have visibility as to what the business was going to look like over the next couple of quarters. That was just at the peak, and we thought it was the trough. But at that time, visibility was very limited. And we didn't think it was the appropriate thing to be executing on it at the same time, while we were in the market saying that we didn't have visibility to what the business looked like in the near term. But we also stated, and I'll state again today, that as we begin to see more confidence in the business model, we'd expect to be executing on our capital allocation model. And our capital allocation model is very simple. We're going to continue to invest in the business. And I will tell you, as it relates to that portion of the model, but we have continued to be investing in capital in the business. There is not a new product development or cost reduction initiative or productivity program over the last 90 days that we haven't moved forward with if we believe it's the right investment within the business. We're still very committed to our dividend. We understand that dividends are important to our shareholders. And then we know that to execute on our higher standard strategy long term. We need to bring in acquisitions into the business that can help enhance our strategy. And if they're going to enhance our strategy, we're going to move forward with those acquisitions. And then as the final piece of our capital allocation model, we repurchased shares. And that is just dependent upon how successful we are in driving those acquisitions. But we believe that's a prudent thing to do for our shareholders and are going to continue down that path as it relates to our capital allocation model, Nathan. And you're right. I think one of the advantages that Lincoln Electric has in this window is that, look, we have not, in any way, slowed down our desire to look at strategic acquisitions. And are we challenged in that we might not be able to go see those individuals in person or see those companies in person? Yes. But I will tell you that we're very actively involved just as we were prior to the pandemic in trying to identify those businesses, those solutions, those technologies, which could add value to the higher standard strategy and the businesses that we have within that, and we would be very open to doing acquisitions if we can find those right targets at the right valuation.

So we've clearly been through a black swan event here that focus people on balance sheet and liquidity. Has this experience changed the way you think about leverage and liquidity? And where do you think the optimal leverage range would be? And at what kind of maximum leverage levels would you be willing to put on the company? And have those changed since the onset of this pandemic?

Yes, I think that's a very good question. I will share this that as I've been watching our business and watching a host of companies in the broad industrial market space and the things that they've had to do to provide more protection to their businesses, I've been very proud of our execution of our capital allocation model, Lincoln Electric. Look, I think our covenant ratios have been -- have held up very well and that we performed very well. So I think that there will be many companies that ask themselves what the maximum amount of a challenge or burden they might put on the balance sheet, depending upon the acquisition that they might be looking at. But I would tell you that it's very dependent upon the acquisition that you have and the confidence that you'd have within that acquisition. I'm not sure that when I have my board meeting in July that I would look at anything different. And in fact, it probably validates the strategy that we implemented a few years ago and the way we were looking at capital allocation here at Lincoln Electric.

Okay. I do have one question on the webcast here, that I'll ask. Your business has historically generated good returns. I would actually call them better than that with high teens ROIC, the way I calculate it. As you look out over the medium to long term, do you think you can generate similar returns? If so, what are the most important factors for investors to consider in achieving such returns?

Yes. Look, I appreciate your comments. I think they have been very solid to exceptional returns. And I believe that we can continue to increase the performance at Lincoln Electric. And when I think about the business, there's a couple of very executable strategies that we see that we need to be able to complete at the company to achieve that. One is continuing to make those improvements in the International business from the margin profile. Portion of that is -- are things that are within our control, driving the cost model, making sure that we have the appropriate solutions to the appropriate segments and the execution of that portion, and then we need some growth. We need some improvement in the European business model, the growth within Europe to assist us. We need some of that volume to be able to achieve those targets. The second element, which I believe is important for us to achieve that is the execution of our automation strategy. We stated in our higher standard strategy that we want our automation and additive businesses to be a $1 billion business when we exit 2025. Today, that business is in the low 400s. And so we've got to do that through strong growth, solid execution and continuing to find the acquisitions that add to that strategy. I've got a lot of confidence in that. We've been doing that the last several years, but we need to be able to continue down that path. And if we do that and continue to invest in the solutions in the business, that's expansion in core welding, that's expansion in the Harris Products business. I've got great confidence in our ability to continue to provide premium returns to our shareholders.

Well, great. We're out about the time there. I'd like to thank you guys for participating today, and I think investors will really appreciate the high level of transparency that you guys have provided here this morning. So thanks a lot for that. I really do appreciate it. And I look forward to catching up with you guys as we progress through the day. Thanks very much.

Thank you, Nathan.