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

Good morning. I'm Saree Boroditsky, industrials analyst here at Jefferies. We are excited to have Chris Mapes, Chairman and CEO of Lincoln Electric, here with us today. We're going to do a fireside chat, so we're going to get right into questions this morning. Unfortunately, the power and Internet is down here in Connecticut, so I can't access audience questions. So if there is anything outstanding after the call, please e-mail me and we'll get that -- we'll try to get those questions answered for you. So I thought we'd start today with some questions around the quarter and growth outlook. And then we'll go into some longer-term strategy questions.

So during the earnings call last week, you talked about seeing the trough in April, with July order trends continuing to show improvement at down high teens to low 20%. Outside of China and Harris, could you talk about some areas where you're seeing a more or less robust recovery?

Good morning, Saree, and thanks for having us. And I think that probably the most important piece, before I get into individual segments, was just the fact that we continue to see the sequential improvement off of that trough in April. We believe that April was a trough, and it was down about 40%, and we just continued to see improvement through the quarter. As we stated, we've seen our Harris business and our China business perform a little bit more positively, especially our Harris business that has a retail element associated with it. And then we've also seen our automation business and our Latin America businesses may be a little bit more challenged as they're fighting with some different issues associated with their recoveries, whether it's large capital spending or some of the specific challenges associated with managing the pandemic in a couple of those other regions. But I really like the fact that we've seen continued improvement broadly across the business as we migrated through the quarter and into July and expecting that although rate of improvement may mitigate, we're going to continue to see sequential improvement through the business as we're exiting the rest of 2020 and into 2021.

And so you highlighted China. China sales are going to have a bright spot in the quarter after being the first to feel the impact from COVID-19. Was the demand that you saw largely on the equipment side? And can you provide any color on what you saw by end market?

Yes. No, the improvements in China were primarily more consumables driven than they were equipment driven in that particular market. I think one of the interesting things about the China business was it was oriented more towards heavy industry and automotive, which maybe isn't what we were seeing globally from those particular segments. But as the markets there in China recovered, those markets that were not exporting materials actually recovered more favorably. And the automotive market there started back up, and we participated in that. And again, it was more consumables than it was equipment-oriented, but it had to do with those markets that are more domestic-oriented in China, and they performed reasonably well. I'm really proud of our team in China. They've experienced more of a sharper recovery than what we've seen in other areas of the world. I don't believe we can necessarily replicate that as we think about other regions and how those recoveries will look. But our team in China has done a very nice job of managing the challenges associated with the virus and the improvements in that business, and we're expecting to continue to see further improvement as we're migrating through the rest of 2020.

And continuing to kind of dig into some of your comments, Harris also saw positive organic growth in June and has really been one of the bright spots for you over the last few quarters. Can you just talk about what you're seeing in HVAC and retail demand for this segment or any other end markets that you'd like to highlight?

Yes. You're right, Saree. We've seen improvements in that Harris business for the last few quarters even prior to the pandemic. And some of that's been an acquisition that we made in that marketplace that we've executed on well that provided some products into the HVAC and plumbing channels. We've made some large investments in that business over the last 2 or 3 years for some new product technologies that moved in towards the HVAC space. And then certainly recently as we've seen the pandemic, one of those areas of our business that has been strong has been retail, and our retail business is managed through our Harris portfolio. It's continued to stay very strong, and we expect that to continue as they're migrating through the rest of the year. Our Harris team has been able to show an ability to respond to the increased demand in the marketplace with the challenges associated with the pandemic. So I'm very pleased with the activities and the execution that we've had from that particular business. So really, it's a very good positioning for them. Continued expansion and growth in retail. We've got new sets. It's not just because of the pandemic. There are things we're doing in that market as a catalyst to see that growth. Investments in new products. Those new products are primarily centered around HVAC and plumbing. And then I think as we continue to migrate through the year, again having confidence because of being able to drive improvements within the Harris portfolio for the last several quarters. I think HVAC for us in Q2, actually the OEM side of HVAC, was really not materially higher. It's flattish probably. But HVAC in general has stayed strong. And certainly with some of the weather challenges that we've seen across the U.S., especially in the summer of 2020, the replacement out of that cycle should stay, I believe, firm as we're working through the rest of the year.

That makes sense. And then I guess on the other side of the coin, automotive is one of the more challenging industries in the quarter. But you mentioned you're expecting to see some improvement through the year. Is that a function of easier comparables? Or are you seeing any signs of increased demand from the conversations with customers?

Well, Saree, I would say really 2 things. First is the automotive side of the the industrial space had a slower start-up from the pandemic. And because they had a slower start-up, I think about automotive, much like I think about the regions of the world. We recognize that Europe was impacted by the pandemic earlier than the U.S., so their recovery has started to mature a little bit earlier than what we're seeing here. When I look at the U.S. marketplace, especially for automotive, of all the segments, automotive was one of the slower ones to start its recovery. So we're expecting to see that sequential improvement in automotive as we're moving through the rest of the year, much like we have seen in the other industries. We do have some slightly easily -- or more easy comps that we'll be looking at for that area of the business. But for me, the bigger catalyst is they had a slower start from the pandemic. We started to see those manufacturing sites reengage. We've seen the consumer out there in the marketplace, at least the data that I've been looking at, with low-cost opportunities. From an interest perspective, the consumer's reacting. So we should see the demand. And I believe that we'll continue to see improvement in automotive as we move through the year.

And then in general equipment demand has held up better than we expected during this downturn. Can you talk about some of the new products or initiatives that are really driving this trend? And are you seeing equipment outperform consumables across all segments?

Well, first, I would tell you that I believe our equipment side of the portfolio has been performing in a positive manner for the last 4 or 5 quarters. So it's been a longer trend for us in the way we think about our equipment portfolio. We just made a real focus 2 or 3 years ago about setting up some SBU formats inside the company and putting the SBU teams responsible for the engineering and the developments of their product categories. And we're seeing more new products. We're seeing more engagement with our customers, voice of the customer activities to be able to drive those technologies into our product portfolio. So we have seen it now for 4 or 5 quarters. And I expect we will continue to see it, especially since I know we're going to be launching an additional 20 new products before the end of the year, and many of those new products are in the equipment side of our solution offering. I do think that when I think about it by segments, it's hard to say that we're seeing much equipment portfolio growth in the oil and gas space exactly now at this point in time. But I will tell you that the equipment growth, in general, is very broad across most of the segments, and we're very happy with the return on the investments that we've been making in the R&D area. And I believe that focusing those teams from an SBU perspective on their products is accelerating technology for us and accelerating our new product introductions.

So I guess, it'd be fair to say that you're probably taking share, outperforming the overall industry from an equipment demand perspective?

I think as we've now had 4, 5 quarters in a row, I think it is fair to say that our equipment is very well positioned, and we're doing very well from an equipment perspective as it relates to the global welding marketplace. Saree, you know us well, and we're not wanting to very quickly talk about market share. I believe market shares move materially or trend over a longer period of time that they just don't occur in a quarter or a month. But now that we've got 4 or 5 quarters of continued performance, I do believe that we are positioned very well from an equipment perspective in the global welding market.

And then Lincoln Electric has been able to manage downturns really well in the past, and we saw this again in the second quarter as margins held up well despite the significant top line decline. That said, some of this was driven by temporary cost cuts or onetime items, such as the incentive compensation. I guess could we start by going through some of the temporary cost actions that you've taken? And do these create challenges as we think about the margin progression in 2021?

Yes. And Saree, if you don't mind, I'd like to start by saying, look, Lincoln has a playbook. Like many companies may think they have a playbook. But we've shown an agility and ability to manage during downturns in the marketplace historically. And certainly, one of the major dynamics of that is our large facility in Cleveland, Ohio, where many of our technologies are manufactured. And the relationship that we have, the partnership that we have with our employees here, and quite frankly, we're willing to reduce our hours instead of maybe laying off or furloughing our employees. And so our employees know that they might go from 40 hours to 36 hours to 32 hours as our demands may move in the marketplace. But we're doing that all the time, irrespective of whether we maybe are in a recessionary market or a market that's got a recession driven from the pandemic that we're all managing in today. So that culture, that ability to manage that allows us to move very quickly. The second comment that I think is as important when people that are thinking about Lincoln Electric think about the way we manage the business is that by having that partnership, we're not aggressively laying people off or doing things that might appear to be more egregious to the workforce. I would tell you in the past, we have done that the challenges for our employees with managing during the pandemic, created a lot of angst and concern, and we didn't want to also potential risk to the employee base by also placing the added burden of that financial pressure, especially when we look at our balance sheet and have the confidence that we have in our balance sheet and our cash flows and believe that we could manage those temporary cost reductions as well as longer-term structural permanent cost reductions without having to take some of those steps. So I feel like we managed the temporary cost very well. That's the travel. That's the entertainment. That's the contractors. That's all of the other expense, and I will share with you that the pandemic is enormously efficient at assisting us and reducing some of those discretionary expenses, probably more so than we've ever seen in the past but being able to manage that as well as the way our incentive compensation systems work. And our incentive compensation systems are providing us a benefit right now, and they should provide us a benefit during these windows when our profits are down. And quite frankly, we're not performing at the level that we had expected to. So when I think about our system, our playbook and the way we want to manage during these more difficult windows, I believe it's working. I believe we've been very effective at being able to drive those temporary costs as well as identify more permanent structural costs that we think can benefit us as we're migrating through the rest of this cycle, which I certainly believe will be the rest of 2020 and into early 2021.

And then I guess on the permanent cost side, how did you think about the 5-facility rationalizations? Were these sites that you had planned to consolidate previously? Or do you think that some of these areas will not recover following the current downturn?

Well, I think one of the benefits that we had moving into the pandemic is that as we were continuing to strategically align our business, especially internationally, to meet our longer-term targets around margin improvement of 10%, we had already started some activity on the facility side in those markets. That work had been defined, and it actually started in November, December of last year. So we were implementing prior to the pandemic. So those facilities were clearly already on our radar screen for the longer-term improvements. As it relates to a couple of facilities that quite frankly were identified in the Americas area, it was quite frankly just our ability to do some consolidation, some trimming of some expenses that we could consolidate into the current framework that we have. Those were not on the agenda prior to the pandemic, but certainly were things that as we were moving through, we recognized that we could do as we were accomplishing some of the longer-term structural cost reductions that we were looking for. And the activity in the Americas really has a little if no impact on any sales. It was really just a consolidation of assets into other facilities. It's how we accomplish the facility consolidation in our Americas business.

That's good to hear. Then obviously, there's still a lot of uncertainty out there, but you've built some inventory, and you've started to release some spending, I believe. So can we take that as a sign that you expect some recovery as we get into the latter part of the year and into 2020? Just maybe talk about how you're kind of seeing the outlook for the business.

Well, as we stated, we continue to expect sequential improvement. I think that rate of movement will mitigate. Obviously, we're not going to have the 40%, the 10% improvement that we saw in the early couple of months coming off the April trough at 40% down. So we're still expecting sequential improvement through the year. But Saree, I'll also share with you, we do expect some improvements in working capital in the second half of the year. So as the pandemic was migrating across the world, we made some business decisions relative to inventory back in February, March and April. And I believe those were the right decisions for the company and, as importantly, the right decisions for our customers. If you go back at that period of time, there was a real concern as to what might happen with supply chains, what might happen with the ability of companies to be able to have employees in their workforce to be able to conduct the most needing products and solutions from Lincoln Electric and us not being able to deliver those. That was especially important for us in the international markets where over the last 2 or 3 years when we were doing the integration with Air Liquide, we believe that quite frankly we were not as strong in this area as we wanted to be. We've done very good in 2019, and we didn't want to mitigate that. So we built inventory during that window and expect actually in the back half of the year to be able to remove some of that inventory as we have more confidence in the supply chain. And we've shown an ability now with the appropriate safety protocols around the world to be able to operate our manufacturing facilities effectively. So continued sequential improvement throughout the rest of 2020 into 2021, although an ability probably way to make some improvements in working capital because of now confidence of manufacturing with the appropriate safety protocols. And we've stressed that supply chain and shown an ability to be able to execute on the supply chain side of the business.

Most of the conversations and outlook obviously tend to focus on the virus, but I wanted to see if you had any thoughts on the impact of the upcoming U.S. presidential election, including the potential for higher corporate tax rate and maybe infrastructure spending. Do you expect this to impact potential demand recovery?

So I will tell you, Saree, when I think about the business at Lincoln Electric, first, I'm probably not thinking about the short-term impact of the presidential election. And I don't think that there's anything there that's materially going to impact the demand side of our business over the next couple of months. I think we're going to continue to see sequential improvement. There certainly could be some actions that come that we'll have to manage through. But we've managed through a host of presidents in our 125-year history, and I'm confident that we'll be able to continue to do that moving forward. I do think that there are elements though that are out there that we're going to have to continue to manage. I believe that the dynamics globally relative to some of the trade and supply chain issues associated with China and the U.S. are going to permeate beyond whatever the final result is of the election process here in the United States, although I will tell you, I view that as a positive for Lincoln Electric longer term. I believe that could be one of the reshoring activities that we should see for manufacturers. I believe that reshoring, if it does occur in manufacturing in the north further automation to mitigate some of that arbitrage on the labor cost. So I see those as a positive catalyst, but I'm not sure that whatever the result is of the election will change that dynamic longer term. I think that's probably something that more and more people are concerned about because of the challenges they've seen with the pandemic and some of the political risks associated with having too much of a supply chain based from that particular partner than necessarily the result of the election.

That makes sense. And then just putting aside 2020 margins, Americans have yet to reach the 20% prior peak levels seen in 2013. How do you think about margin improvement in the segment? And do you think the lower margins are structural? Or what can Lincoln do to get back to that higher level?

Well, I would tell you that I think one of the big opportunities that we have for us as we are talking about making the improvements in the margin profile in our Americas business is showing that we can get our automation business back up growing and growing at the margin profile that we'd like to see. We've had some challenges with that business over the last 6, 12, 18 months. And I believe that that's one of those catalysts that can get us back on that path to meeting those long-term margin targets. The other thing is we're continuing to make those investments in the equipment side of our portfolio, richening our mix. The SBUs that I talk about are not just SBUs that are driving things on the equipment side, but also driving improvements in accessories. Although a very small category inside of Lincoln Electric, a category that's been growing very nicely for us. So I think the richening of the mix is also going to assist us on the margin piece. And then Saree, look, we're a manufacturer, and we just need to continue to be passionate about operational excellence. And we have an initiative within the company to put more focus on the Lincoln business system, but more focus on driving more productivity throughout the enterprise. And I believe that is another catalyst that we need to have to drive to return to the margin profiles that we'd like to see for that Americas business long term. And then you saw even during the downturn where we've been willing to take actions to structurally make further improvements in the business here in the Americas. And I think all of those things, when we take them in the aggregate, are critical for us to be able to meet that target on a longer-term basis. Obviously, when I think of all of them, I'm really excited about that richening of the mix and the improvements we've been making on the equipment side of the portfolio. And then I just believe that structurally, the investments we've made in automation are the right investments, and we're going to see improvements in that business over the near term.

And then I mean as -- sticking on the margin side as we think about your long-term target for international margins of 10%, how much of that is really going to be volume-dependent? Is there anything else that could be done to improve the margin profile of that business? And then secondly, could this segment get higher than 10% margins over the long term? Or is there anything structural that would keep it lower?

Well, I think I'd like to answer the second question first, Saree. So I would love to be back on the call with you and tell you we've achieved the 10% and we set the next target level threshold for that particular business. I don't think that business is going to perform ever at the level that we see in the Americas business. There are some structural differences between those markets. But there's no reason why once we've achieved the 10% improvement, that we shouldn't be setting advanced margin targets for that portfolio. I certainly don't think that the 10% is the ceiling. And then as it relates to the first question, I would tell you that volume always helps. But when we've evaluated the business, we've recognized that volume has been challenged in those markets. And we've tried to be able to drive a structural improvement in the business that can get us close to achieving that 10% target without significant volume improvements. But certainly, I'd love to be seeing some volume improvements in the business there in Europe. That would give us a tailwind associated with reaching those targets, but I am enormously confident that with the structural improvements and the cost changes that we're making in the business, that with the improvements we're making on the service side of our business from a customer service perspective of serving our customers and driving those products to the marketplace, we're seeing more and more of our solutions being driven into the global markets. One of our highest performing product categories on the equipment side of the business in 2019 actually had more sales globally than it had in the Americas market. That's an example of our continued desire to drive those solutions around the world. So we believe and have great confidence that we're going to achieve that target. And then we need to be able to step back and say what are the other things we need to do to make continued improvement in that margin profile longer term. But our teams are working very hard on the international side. And I believe that once we completed these structural improvements in the business that we have in front of us, that we'll be able to achieve that target without significant volume improvement. But certainly, we would like to see volume improvement as a way to assist us to get to the target.

And then during the last earnings call, you mentioned that you're continuing to evaluate M&A opportunities. I know that activity has really been on pause given COVID-19. But have you seen any opportunities given the challenging market environment? And then outside of automation, are there any other markets that you're interested in targeting there?

Well, look, there are always markets that we're interested in targeting as we continue to drive our higher standards strategy. Our -- And look, I would tell you, any time we can find some strategic solution, something that's unique that we believe we can add to our portfolio, then we have an interest in it when we're talking about the global welding, cutting and automation marketplace. We've seen a couple of very small transactions that were available to us during the last couple of months that we're evaluating. But I would tell you that I don't think the M&A market has changed dynamically and the way that we're looking at businesses today. Most businesses were recapitalized. But I will tell you that Lincoln Electric has got a lot of confidence in its balance sheet, a lot of confidence in its cash flow. And we haven't changed our mindset around M&A., and if it's available in the marketplace, then we certainly want to be able to execute on that. And Saree, I believe that we only have maybe time for one more question as we're closing out our session this morning. Well, Saree, not hearing a question from you, look, I know that -- first of all, I'd like -- I commend you for the challenges that you had in Connecticut this morning without any power, without any internet and operating the fireside chat this morning. We greatly appreciate your support of Lincoln Electric. I would tell you again that we thank everyone for being on the call. We have great confidence in the continued improvements that we expect to see in the business as we're migrating through the rest of 2020. And I just need to thank all of our employees around the world for their commitment to the company and their commitment in managing through the challenges associated with the global pandemic. And I look forward to seeing or talking to all of you as we continue to advance the strategy for the company over the next several months. Thank you.

Thank you again for joining us. We really appreciate your support.