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

Great. Good afternoon, everyone. We're going to keep going here with Lincoln Electric. My name is Dillon Cumming with Morgan Stanley. I'm one of the firm's U.S. machinery and SMID-Cap Industrials' analyst. Before we begin, I need to read a quick disclaimer. Please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at, www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So with that, we have Lincoln Electric, which is a global leader in the production of welding, cutting and brazing products. I'm very pleased to have with me today, Gabe Bruno, CFO; and Amanda Butler from Investor Relations. Guys, thank you for being here today with us.

Hi.

Hi.

Thanks for having us, Dillon. Great to be here.

Great. So we're going to jump straight into the Q&A. [Operator Instructions]

So with that, you guys obviously published an 8K this morning kind of commenting on sequential trends. You said that orders were down in the high teens in July with further improvement in August. I guess, first, can you just comment on the magnitude of the improvement in August? And I guess, is the expectation that, that momentum kind of continues through the course of September?

Well, Dillon, in general, we're pretty pleased with how our commercial teams and our operations teams have navigated a very challenging environment. And so we wanted to highlight just the progression of our business in July. We ended at high teens year-over-year type of trends reduction year-over-year. We had talked about high teens, low 20s in our analyst call for the second quarter, so we wanted to firm that up and then continue to improve into August. Now August is a challenging month to gauge. It's just with all the traditional shutdowns in various markets, it's always hard to gauge. But we feel pretty confident that we continue to see continued improvement in our business. And although a bit cautious on the momentum of that level of improvement.

Yes. That makes sense. And I guess as you think kind of regionally, are there any areas where you've seen kind of incremental production disruption or kind of like fresh production shutdowns as a result of the recent resurgences in both the U.S. and Europe?

Nothing incremental. So we've been in production modes in all across our regions. The improvement that we've seen is across all regions, all segments. And in fact, the Harris segment is actually up year-over-year in demand. So that has been more positive. So really, all of our businesses continue to operate in this recovery and continue to progress the level of engagement and operating a safe environment.

Got it. And I think you had said last quarter too that the Americas were lagging Europe a bit from a sequential perspective. I guess is that still the case now that we're seeing kind of higher case counts in Europe? Or what's kind of going on between that dynamic?

Yes in general, Dillon, it's a dynamic of kind of first-in, first-out. And that's what we saw as we ended the second quarter, and that's what we see progressively into the third quarter. So we had ended second quarter Americas volumes down 29%. International was just shy of 21%. And we saw that same type of mix, still improving. But again, first-in, first-out in terms of the level of demand improvement.

Got it. All right. Maybe switching over to kind of decrementals and cost savings. Last quarter, you guys posted decrementals in the low 20% range, pretty admirable considering the degree of business disruption going on through the quarter. I guess, to what extent do you guys feel like that performance is sustainable here through the back half of the year?

Well, we're very confident that we'll maintain that low 20s decremental, and the key challenge there is that level of restoration of temporary cost actions and the related savings into our business. And that's going to be really driven off of what we see in volume and the recovery. So we're confident that we'll continue to maintain that low 20s type of decremental into this third quarter.

Got it. And maybe as you look to 2021, as you kind of alluded to, you guys have enacted a large degree of temporary and permanent cost savings pretty rapidly. Do you guys still have any levers to pull if the end market backdrop stays a bit lower for longer in 2021? Or do you feel like you've kind of exhausted those efforts at this point?

Well, we always have other levers to pull. I mean we've executed on our playbook, I believe very effectively. In fact, some of the temporary cost savings were more accelerated as we progress throughout the second quarter than we anticipated, so it's been good progression there. I think the key challenge is to really tie in the restoration of those activities into real volume improvements. And so we're anchored on our traditional business model. We believe that as volumes increase. And let's say we're in that low to mid-single-digit types of increases that we'll follow our traditional business model, which would be incrementals in that low to mid-20s. So we're going to be tracking our actions that align to volumes, and we're progressively anchored on that kind of progression.

Got it. That's very clear, Gabe. And then maybe kind of switching over to the end market trends to the extent you can kind of have an outlook on the back half of this year, 2021. You guys have a broad range of kind of industrial exposures, obviously. Can you maybe just kind of tick through your expectations at a high level for your end market mix? Both back half of this year and 2021. And maybe just a sense of which end markets may take longer to kind of recover post-COVID?

Sure. So we like to communicate across 5 different end user segments, and I'll comment on each of them. So think about 1/3 of our business is tied to general fabrication, and that's really catch all industry of all the other industry segments that haven't been identified. So that's about 1/3 of our business. And you've seen over the last couple of months, a good progression in an expansionary type of potential. When you look at the ISM Purchasing Managers Index for manufacturing and we look at industrial production. And that's really both in the U.S. and Europe, and you see that in China. So we've seen more positive progression around general fabrication, and that's consistent to what we saw in the second quarter. I mean if you look at just how we -- our overall business progressed and much more positive, general fabrication, definitely more positive. As we entered the third quarter, we've seen a shifting to a more positive trajectory into the automotive transportation segment. And that had been lagging. For the large part of the second quarter, the automotive sectors were pretty much shut down. And so we saw good progression now into this third quarter on the automotive side. And I'd like to think about the automotive industry kind of split into how it impacts our business into 2 parts. You see real factory activity tied into production. And we were anticipating production levels to get back to the pre pandemic levels around that 90%, 95% by the end of the third quarter into the fourth quarter. So we're seeing that level of production currently, and then relaying demand into our business at that level now. So that's been more positive as we enter the third quarter on the automotive side. The other component that has more longer-term indications is on capital investment, so that ties largely into our automation business. So we're still seeing kind of a hesitancy in committing capital. Still here of maybe 6 months out or so and looking at the new model years and investment related to that. So that part of the automotive sector is still -- we're a bit cautious on in terms of real demand. But in terms of production, that's been more positive. That ties into our core welding business and our consumable activities. So that has been positive now into the third quarter. The other positive industry segment is on the infrastructure construction side. And then many of those components of businesses were classified as essential through the pandemic. And so we saw that demand hold up throughout the second quarter. And then as we got into the third quarter, continue to hold up. So that represents about 10% of our business. That remains pretty positive with a longer-term positive potential trajectory and opportunities for continued investment in infrastructure. So automotive, transportation, infrastructure, construction, general fabrication, more positive trends. Heavy industries has been lagging our overall demand patterns. And that's not surprising. As we entered 2020, even before the pandemic, we knew that we were coming off of peaks from the heavy industry level of capital investment. And so we knew we'd have some pressure on demand into 2020. The pandemic kind of exaggerated that dynamic, and we haven't seen anything more meaningful improvement in that although customer sentiment seems to be more positive. We know, for example, in the mining industry that, that industry is dealing with some aging levels of equipment and investment there. And so we know that will turn around. We just haven't seen that commitment to capital yet. And so that's progressing. And then lastly, the energy sector, and energy sector represents about 22% of our overall business, of which the biggest component is oil and gas, and that's about 15% of our business. And so there's typical -- typically a lag of 6 to 9 months between when we see a change in overall patterns, in particular, the low pricing and where that impacts projects and capital investment. And so during the second quarter, that part of our business held up. That was actually more positive than the overall trends. But we've seen that now, slow somewhat now into the third quarter. And with oil prices remaining under $50 a barrel. And just yesterday, it was slightly under $40. We'll see that continue. So that's an area to be cautious of, and that is continued progression on the oil and gas. We see it positive, though, when you look at renewables on the energy side, particularly in wind, it's been more of a positive trajectory. And so we expect that to continue on with some momentum there as well. So that's kind of a high level trajectory of the end user segments.

Got it. That's a really helpful framework, Gabe. And maybe just on that last point you made there on the renewables part of your business. How much, I guess, of your revenues, does that account for today? How much of a growth driver could that be over the next maybe 1 to 3 years, call it?

Yes. So that's about 7%. So overall, energy, 22%, peel off oil and gas at 15%, so 7% of that really is driven by renewables and then wind has been good.

Yes. Okay. That makes sense. Maybe switching over to some longer-term stuff here. Automation. That's really been one of the more attractive kind of secular growth drivers for your company. And in captives in general, and it's certainly been an important part of your story. I guess there was some volatility in the business last year, you guys were clear about that. But how has that business performed year-to-date versus kind of the non-automation average?

Yes. So you're right, Dillon. When you think about long term, we're really excited about the portfolio of the business we pulled together on the automation side. Before the pandemic, you saw the unemployment levels were at all-time lows, as you're thinking about manufacturing employment and just the drivers for long-term capacity requirements. And we know that as the welding experts being able to automate capabilities within the factory floor, that's going to be a key long-term driver. And we think about that as being 2x core welding type of growth because we see those secular components within the markets being a driver for growth. So that's real positive. Now you're right. Over the last 18 months or so, we've been dealing with a much slower capital market trajectory. The trends there haven't really changed. In the second quarter, we actually had a more favorable trend in our automation business than our overall business, but that's largely a function of projects that were booked into the latter part of the fourth quarter 2019 into the first quarter. So we haven't seen the full impact on the deferral of capital investment in our business. We expect more of that into this third quarter into the fourth quarter from an automation standpoint. But we're very excited about the opportunities that we have in automation. We've got a lot of conversations about reshoring, what that means in terms of the long-term trajectory of our business. We're real confident that we'll build out the portfolio that's aligned to our Higher Standard 2025 Strategy. For those on the webcast, who are following us, we've put forth our target of being $1 billion in revenues across our automation additive business by 2025. So we're excited about that opportunity.

Got it. And then maybe can you spend a minute talking about the differentiation of that business versus your larger welding peers, how your strategy differs and maybe why you feel like you have the right kind of path to market there?

Yes. So think about an automation level strategy that provides a level of intimacy with our customer base. So our business is largely done directly with OEMs where we're solving problems. So we're introducing our know-how with metallurgy, with robotic capabilities, with automation capabilities, we will solve our customers' problems. So it's very much an intimate relationship in working with our end users to be able to work through solving their automation needs and using -- leveraging our welding capabilities, our welding expertise and the capabilities within our automation framework.

Got it. And I guess maybe just wrapping up that theme, thinking longer term, you've said, I think that, that business is directly tied more to automotive versus your other end market exposure. I guess, what does the pipeline of opportunities look like in your other end markets and what would it take to kind of drive greater maybe non-automotive penetration over time?

Yes, it's a great question, Dillon, because you're right. Historically, we've largely anchored around a automotive, heavy industry type of capital project business. And that's driven because of the maturity of those types of industries and really embracing automation as a means to drive quality, efficiency, productivity into the plants, and meeting the capacity needs. We have spent more and more time broadening out our general industry type of engagement. There's an opportunity for us and looking at, for example, pre-engineered solutions that can reach out to a much broader part of the markets. And that excites us, right? That’s a nice avenue for us for growth. And where the markets begin to more deeply engage in automation capabilities with the pressures of looking at skilled labor and unemployment levels and capacity requirements now we believe that, that's going to allow us more accelerated opportunities for growth.

Got it. That's helpful. Maybe last one on the automation then. The reshoring thematic has been one that's been kind of going across cap good. Supply chains moving back to the U.S.. Kind of along that theme, have you had any kind of initial conversations with kind of Tier 2 to Tier 4 suppliers who might need to look at automation in order to service that incremental demand? And I think as you alluded to, welding related unemployment was at record lows, kind of pre-COVID. So to the extent you're having conversations there, any color, or you could give would be helpful.

Yes. So Dillon, it's a lot of conversations you can manage, right? Talking about positioning for capacities with the reshoring. We haven't seen a meaningful investment and commitment to capital to really drive that kind of incremental level of demand, but we're positioned for growth, and we've got the capabilities to be able to meet that need. So a lot of conversations, we have not yet to see that to translate it into meaningful demand.

Got it. Okay. Maybe switching over to the segments and some margin targets. Starting with International, that's obviously a segment where you've been vocal about your desire to reach a double-digit margin level in that business. Can you just remind everybody what exactly has capped margin expansion in that segment to date? What will you need to do to eventually kind of reach that 10% margin level?

Yes. So Dillon, we're very confident that what we've done to integrate the Air Liquide Welding business that we had acquired in 2017 and now fully integrated the commercial, the brands, the products, the operations. And there -- we don't talk about Air Liquide Welding as a separate business anymore. So we have done -- taken the tough actions, we've done the integration, we've integrated systems to be able to launch that platform. Now 2019, we went into the year with very soft industrial macros, particularly in Europe. And so we're confident that we've made the decisions to build out a business model that once we start seeing some level of expansion. And I'm not talking about a lot, but going back to like 2019 baseline, which is what I've talked about on the call for the second quarter, with some level of expansion, we feel confident that we can achieve that 10% EBIT margin targets that we've established for our team.