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

Great. Good afternoon, everyone. My name is Dillon Cumming. I'm one of the machinery analyst here at Morgan Stanley, covering the space together with Courtney Yakavonis. We're going to keep things moving along here with Lincoln Electric, which is a global leader in the production of welding, cutting and brazing products. Before we begin, I'm going to read 1 quick disclaimer. 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. I'll just remind you that please send your questions to Lincoln Electric team during the session. Please feel free to submit a question via the webcast browser. So with that, I'm very pleased to have with me here today Gabe Bruno, CFO of Lincoln Electric; and Amanda Butler, Vice President of Investor Relations. Gabe and Amanda, thanks for being here with me today.

Thanks, Dillon, great to be here. And thank you all for your interest in Lincoln Electric.

Great. So we're going to kick it right into Q&A. So Gabe, just starting with kind of near term and kind of quarter-to-date trends to the extent you can discuss it, last quarter, you saw some very positive top line momentum across the portfolio, both the consumables and the equipment product lines, and we saw volumes up 26% in the quarter, a very strong outcome. Can you just kind of level set expectations around your primary end markets through the end of the year and kind of into the next year as well?

Yes. So Dillon, thanks for that question to start off. Yes, we had very strong momentum going into the third quarter, record levels of backlog into the -- which is really consistent to what we saw going into the second quarter. So really broad-based types of strong demand profile. When you think about end markets, I like to think about 80% of the end markets that we serve were in the growth mode, and very excited on what that means and broad-based industrial activity. We had much more confidence on the call regarding the beginning stages of an expansion, and we're pretty excited about what that means. The only market that we continue to see softening trends were in the oil and gas, of which we believe that in a progressive -- maybe the beginning stages of a recovery. So we're pretty positive in the kind of industrial expansion that we've begun to see.

Yes. That's definitely very encouraging. Maybe we can just hone in on transportation for a moment we were discussing before. You can just kind of reiterate some of your prior commentary about what you're seeing in that end market in particular, especially as it relates to some of the production disruptions around the chip shortages.

Yes. So our second quarter, we were up almost 100%. Now that came off of a trough in the second quarter of last year. But the way we see the automotive industry is that you got strong consumer demand, you have low inventory levels. And while the production dynamics may push some of that quarter to quarter, we still see very strong fundamentals. And so while a stabilizing impact may be extended into 2022, the fundamentals are strong, and we're pretty excited about our positioning within the automotive industry.

Got it. And maybe if we can switch over to incrementals and kind of cost savings and that's an area where Lincoln has been outperforming very nicely over the past few quarters. Last quarter, you saw incrementals of 26%, which is kind of at the high end of that normal range you would normally be seeing. I'm just curious, given that you're still anticipating kind of incrementals in the high 20% through the end of the year, can you just talk a little bit about the drivers of that level of margin improvement, especially in the context of lapping over the temporary cost savings that you incurred last year?

Yes, sure. So yes, you're right. We anchored around the high 20s-type incremental margin profile for the full year. And a couple of key things to note. One is the progression of our International segment. You saw in the second quarter, we arrived at our targeted double-digit EBIT margin profile. And so it is very exciting to see how all the structural changes, the business plans that we've been executing on begin to be realized there. So our focus there is now sustaining that double-digit EBIT margin profile and then continuing to improve from that. So we're pretty excited about the contribution from our International business. Then when you look at the Americas business, when you think about the progression within the automation business, we're starting to see improving margins there as well. And so that would also have a strong profile within the Americas segment. On top of the core welding business continuing to improve, the demand profile and the margin mix there continue to be a positive. That in the context of broad price/cost dynamics. We've been managing it in a very disciplined way on the material inflationary types of pressures. And we were neutral for the first half of the year, and that's really our posture for the full year. And so those types of dynamics give us confidence in that high 20s type of profile of incremental margins.

Yes. No, it definitely makes sense. And there's definitely some stuff in there. I want to unpack later on in the discussion. But maybe just to put a finer point on kind of one of the comments you made in the beginning of this conversation is around the kind of length of the industrial cycle. I think you reiterated Chris' comments about being in the early stages of a broader industrial expansion, kind of multiyear runway for growth across your end markets. I'm just curious, which verticals in particular do you see the greatest runway for growth? And where do you feel like there might have been a level of underinvestment and where are you most positive in terms of that multiyear runway?

Yes. So I always enjoy really thinking through the various components of the end markets, but I'll start off with real quickly automotive transportation. As I mentioned, fundamentals are strong. It may take some time for some of the production challenges to be stabilized. But you have this whole dynamic of also a structural change between combustion engine and EV and pretty active type positioning in terms of longer-term capital investments. So we look to that to be a structural change. We all know of an automotive sector is going to be interesting in terms of real capital investment in the long term. And when you look to heavy industries, that's about 18% of our business. That segment had peaked in the early part of 2019. And you saw progression into capital investment pullback throughout 2019. And then with the pandemic drive to conserve cash that also drove some contraction in terms of real capital investment. We saw some of the fundamentals going into 2021 that pointed to maybe midyear expansion in heavy industries, and we just have seen that accelerate. So a lot of discussion, as you know, into construction or in ag or in mining or some of the fundamentals had pointed to longer-term capital needs and maybe refreshing of some fleets in that, particularly on the mining side. So there were good fundamentals there that pointed to a longer-term growth drivers in heavy industries. So we saw an acceleration of that. So obviously, we haven't gotten back to our peaks but to see the beginnings of an expansion there and a real drive to expand capital investment in heavy industries is real positive. So that's really nice to see. General industries, which is about 1/3 of our business, we saw nice expansion. We all measure in ISM, PMI-type indices. And that's been broad-based. And so it's beginning in the second half of last year. Again, that trajectory has continued throughout this year, and you see good activity from a general industry standpoint. Then on structural. Structural is about 10% of our business, and we expected much more choppiness throughout this year, but it's been more steady. I mean we have nice growth trajectory for the first quarter, second quarter, good momentum into the third that points to just good healthy investment from a structural standpoint. And so that's 80% of our business. And so we can point to beginnings of really solid expansion and good fundamental drivers for growth. And we're still -- we talked about beginning stages of recovery on the energy side particularly tied to the oil and gas, and that points to maybe middle part of 2022. So good, broad fundamentals when we think about an industrial expansion, and that's what excites us about now navigating into that kind of environment and turning to growth focus, which is what where we're at.

Yes. No, that's certainly very helpful color and definitely good to hear. Maybe we can kind of pivot the conversation over to automation, which I know is one of the more exciting growth opportunities for Lincoln. But obviously, that part of the business grew at kind of a mid-teens level in the quarter. It did lag the recovery in consumables and kind of broader equipment to some degree. But just curious, first of all, I guess, when do you expect that kind of product line to start outperforming the kind of broader portfolio average?

Yes. So we're pretty excited about where our automation business is at. I'd just remind us, when you think about second quarter activity, second quarter for automation was in the trough because we still had projects that were working its way through the beginning stages of the pandemic. So when we had high teens type increases in growth and automation as a real positive. We had pointed to an increasing level of backlog, a lot of quoting activity that's very healthy. And so we think we're very well positioned for an expansion in capital investment which takes us broadly into automotive, takes us into heavy industries as well as general industries. So we're very well positioned for accelerated growth from an automation standpoint. Very positive about that.

Yes. Sure. And I think anecdotally it is something we've been hearing from a lot of the companies at the conference so far, but there's just been a lot of conversations about lack of skilled labor out in the market, especially on the manufacturing side. Welding was arguably a skilled profession that was in short supply even pre-COVID, right? So to what extent have those conversations on the automation side become more need-based versus want-based?

Yes. No, I think that's key, Dillon. I mean when you think about -- you're right, this was occurring prepandemic where there's just pressure on fulfilling labor demand requirements within the manufacturing sector. And this is why we have invested as we have in the automation side of our business portfolio. So we think that's some one of those longer-term trends that are -- that isn't going away. I mean we're automating within our businesses and our factories and we expect a continued need for manufacturing to continue to invest in automation. So we're very excited about that as an opportunity for us to drive an accelerated level of growth.

Yes. No, that definitely makes sense. And then maybe can you just remind us what the mix of auto versus nonauto is for this business. I think you alluded to opportunities on the heavy industry side, on the general engineering side. How does that split of revenue compare today? And then I guess going forward, what do you need to see in order to drive greater penetration in those nonauto verticals?

Yes. So I'll start off. We had -- we're tracking automotive probably less than 50%, maybe in the mid-40s of our business on average. But we intentionally acquired a couple of companies that were into the appliances industry and into general industries. And so that's been intentional positioning for our automation capabilities. So that allows us to not only migrate to as we have through the heavy industry pullback in capital investment over the last couple of years but also to reposition ourselves to be able to attract a broader base of general industry activity. And that's really a function of really introducing the automation capabilities, robotics capabilities within those types of industries that will allow us to accelerate growth. We've introduced co-bots, for example, that simplifies the level of integration within the robotic capabilities. So general industries, we think is going to be an accelerator to drive our positioning from an automation capability standpoint.

Yes, that definitely makes sense. And then can you just remind us how LECO's automation strategy might compare to that of some of your larger peers. I think you've been vocal about wanting to have more of a role on the integration side of things. But just first speak to that and then how that might better position the company in the kind of current cycles of quoting activity?

Yes. So I think long term. So we've positioned our automation targets to be $1 billion target in 2025. I mean we have intentionally invested in capabilities and accelerate it through acquisitions our broad-based positioning since mid-2015, '16, '17 and progressing to today of really enhancing our footprint. So we are -- have differentiated ourselves with the other top 3 players in this industry to really put a lot of focus on automation capabilities. And we think that's going to drive an accelerated level of growth. So for us to arrive at that $1 billion target is going to be a mix between pure organic growth, which we believe is going to be accelerated 2x core growth in welding. And then we'll have continued focus on acquisitions. It's about 50% -- 50% of the growth is going to come through, sorry, organic growth and 50% through acquisitions.

Got it. Yes, that definitely makes sense. And I think historically, too, the automation business had been more Americas focused as well, and maybe this does tie into some of the other end markets you're looking at as well. But to what extent do you feel like there's actually an international opportunity for this business as well?

The international side is going to be a great opportunity for us. You're right in how we've developed the automation footprint. It had been targeted and aligned with our robotics capabilities and partners there. So we've built out capabilities in North America with a lot of focus on integrating those businesses. The international footprint, we continue to drive that. The acquisition we just completed in April was based in Europe. This is pretty unusual here to lose your voice in middle of a fireside chat. But we're pretty excited about how the footprint continues to evolve. Large focus in North America because that's where really the capabilities had developed, but very much our International provides us an area of growth that we have a focus on as well.

Got it. Yes, that definitely makes sense. And then maybe just wrapping up the kind of conversation on automation. The margin side of the portfolio. I think in the past, you talked about some integration efforts and then kind of broader improvement initiatives on the operational side that should help to kind of lift the margin profile of this business over time. I guess in terms of like how investors should think about growth in the automation revenue line. What does that say about the implications for incremental? Should we think about that being above the kind of range of 20% to 25% that you've played out in the broader business? Or what would you kind of say there?

Yes. I would start off and just remind us that our target for an automation business is the corporate average EBIT margin profile. And so we've been operating about half of that in the last couple of years. Because of the fixed cost structure we have in automation, you would expect higher levels of incremental margins. I apologize.

It's okay.

Talking all day long, I guess you lose your voice sometimes. But we would expect incremental margins to be more accelerated because of the fixed cost structure. We are targeted again at the 15% operating margin profile. As we improve that, we should see better margins on the Americas side. But inherently, the margin profile continues to improve. The work we have done to consolidate and integrate the acquisitions over the years do position us for that corporate target. But we still have some work to do to be able to arrive at that.

Got it. Yes, that definitely makes sense. Maybe kind of pivoting the conversation over to M&A, and you kind of alluded to this too in terms of some recent automation acquisitions that you've made. But I think this past year especially has represented kind of notable acceleration in your M&A activity after a kind of a year of more limited activity. Obviously, you purchased the automation assets via the Zeman acquisition. You had some more kind of core acquisitions via FTP and Shoals. But just first of all, curious how you kind of characterize the pipeline of opportunities and how you're kind of baking that into your '21 outlook?

Well, we have a very active pipeline. Very focused, as you know, in our growth strategy between organic growth but also through acquisitions. The 2 acquisitions that we have completed so far this year have really appreciated -- drives our positioning within automation but also shows the footprint on Harris and the focus in a broad acquisition strategy. Portfolio is very active, and we continue to use that as a leverage to drive growth. So we'll continue to drive that level of activity within a pretty active portfolio.

Yes. And maybe just to hold on to one of those last comments there. I think FTP and Shoals in particular, just wanted to spend a minute there since those are your 2 most recent acquisitions. Those were 2 deals that were focused on the Harris segment, historically not as big of a focus maybe for the company or even on the M&A front over the past few years. What about those assets made it attractive? Does this signal a broader desire to keep reinvesting in the Harris business as well?

Well, we're really excited about our Harris business and where there are opportunities for us to position resources, we'll do that in Harris. But what I like about the Harris acquisition is that it shows the market a broad focus in acquisitions. Harris really have made -- we made a lot of progress in our Harris business model where we see an attractive opportunities. This still happens to deepen our position within the HVAC market, gives us broad capabilities to continue to serve those markets. But our acquisition strategy is broad-based. So whether it's extending on our core welding business or tied into automation or tied into Harris, we're looking at opportunities across our business segments to be able to drive accelerated growth.

Yes. That's definitely good to hear. Maybe if you can kind of move over to price cost quickly. I know you kind of level let expectations. You reiterated that you plan to be price cost neutral for the full year. But I think the pricing line, in particular, has been a pretty notable standout for LECO, especially in kind of the current environment. You've been able to price very effectively. And clearly, you're kind of at the forefront in terms of offsetting those inflationary cost pressures. I'm just curious if you can kind of talk a little bit about how fluid your pricing mechanisms are, how receptive the market has been to your pricing actions and what you feel like the appetite or receptivity might be to kind of future price increases in the back half of the year?

Yes. So Dillon, as you know, we're very disciplined in terms of monitoring, managing material cost inflation and then responding to that with price actions to protect our cost position. So price cost, yes, you're right, 6 months we're neutral, we're slightly positive in second quarter, slightly negative in the first quarter. That's our posture for the year. And we're just very disciplined to ensure that we have the pricing actions in place to be able to respond to what we see in the market. That applies to both the Americas and the international segments. On the Harris side, it's more of a mechanical-type process that we have in place for the commodity escalations that we have seen like in silver or copper. And so we have a pretty mechanical process to respond to those kinds of changes in commodities in that segment. But in general, expect very disciplined approach to navigating material cost inflation to be able to be responsive with pricing actions and maintain that neutral posture as it relates to price cost.

Got it. And we've got about 10 minutes left. So I just want to remind the audience, if you do have a question for the management team, feel free to submit it via the webcast browser, and I'll pass it along. But maybe just sticking on that theme, obviously, you mentioned LECO is one of the more disciplined players in the market. But just curious if you've kind of observed any evidence of undisciplined behavior from your peers, especially in kind of the smaller end of the spectrum or whether or not because we're in such a broad-based inflationary environment, maybe there is just a broader market discipline this time versus prior cycles?

You always don't have pockets of competitors that may try to leverage pricing. But in general, the industry is pretty disciplined and understand the dynamics between material cost and then response with pricing actions.

Got it. And maybe we can widen the lens, maybe to include kind of the state of your own supply chain. I think that's been another hot topic at the conference so far. I'm just curious how you kind of characterize the state of your supply chain with regards to your own labor requirements, freight, things of that nature. Whether or not you've seen any evidence of kind of broader component and material shortages that might be impacting production schedules on your end?

Yes. So I would just say that the supply chain challenges are very broad and hasn't really changed throughout the months. We intentionally, beginning in the pandemic, we decided to invest in inventories to be able to position, to be able to serve customers with all kinds of dynamics going on within the supply chain through pandemic, through labor, throughout component supply. And our teams have just done a great job in navigating the challenges and be able to respond to whatever shortages and challenges that we would have seen in our business. And if it requires our engineering team to work with our manufacturing team to be able to introduce a substitute in a component and the dynamic, our teams have done so. Operating environment, very challenged, but our teams have done a very effective job in being able to navigate and ensuring no material disruptions with our customers.

Got it. And then just on the labor side, I mean, are you seeing anything more acute there versus prior cycles that you're working to offset?

Labor, very challenged and that environment hasn't changed prior to pandemic, during pandemic. That's 1 of the things we point to in the requirements to drive an automation strategy but very challenged. But again, we're doing what it takes to be able to serve our customers in a very challenging environment.

Got it. That's good to hear. Maybe moving on to kind of the longer-term targets for the business. You spent some time at the beginning talking about the double-digit margin path within the International segment. You've obviously made a lot of progress, especially over recent quarters in reaching that. But just curious, outside of this broader volume leverage, what really has driven that elevated level of margin improvement for the international segment? And what would you kind of characterize the runway as over the next few quarters?

Yes. So we've made a lot of structural changes in our business to really position the model, particularly on the international side to double-digit margins. We mentioned historically, the acquisition of the Air Liquide Welding business and all the integration actions we've taken to drive that business model profile that we expect. We'll continue to drive a continuous improvement type structure within the International side. When you look at that in the context of our consolidated business, we're looking to 50% target in OP. We pretty much are operating under that framework. Throughout an expansion, we expect to be up 150 basis points on that. On the contraction, maybe down 150 basis points from that. But we're pretty excited about our -- how we progress our operating model. And we talked about on the International side coming out beginning of 2022 with some refreshed targets on the International side, but really executing on all the business plans across our business to be able to arrive at those targets have been very successful.

Yes. That definitely makes sense. And we'll keep an eye out for those future targets. And maybe just going to get a teaser around that. I mean longer term, is there anything that's actually holding that segment back in terms of reaching Americas like margins? I mean would you consider anything structural about the business, any kind of geographical restrictions that might prevent it from actually reaching a level comparable to the Americas segment?

Yes. So the business models are different. The cost structures between the Americas International margins are different. So we're not going to target an International margin to be in line with the Americas margin, but you could expect continuous improvement within that International business to be able to drive higher margins in the long term. The variable cost model, the fixed cost nature of operating in Europe and other parts of the international markets are different. But we'll continue to drive improvements within the International margin profile.

Got it. That's good to hear. And maybe switching over to Harris for a moment. I think that was a business that obviously performed extremely well through the course of COVID. You alluded to some of the reasons why it was attractive from an investment perspective with your M&A comments. But just curious, looking to the back half of this year into next year, how sustainable do you see the current level of volume performance, I mean, again, just given that it didn't really see the same level of decline that the rest of your kind of core welding product lines did through the course of COVID.

Yes. So I mentioned, we're pretty excited about our positioning at Harris. And that being said, though, the comps will be challenged. I mean we've had very significant growth on the retail side of our business, which is about 1/3 of the Harris segment that progressed through the second quarter. The comps will be a lot more challenging when you look at real volumes from a retail business. And then you have more of a traditional seasonality off of HVAC. So comps will be challenged, particularly on the volume basis, but we're very excited about our positioning within the Harris segment. EBIT margin profile within that mid-teens type of profile but good strength within the Harris segment, but comps will be a bit challenged.

Yes. That definitely makes sense. And as we come up at the end here, I'm just going to wrap it up with some kind of broader, maybe, market questions. Thinking to market share, that's an area where I'm not sure if you can kind of talk about how that's changed over recent years, how you would view your own share versus some of your larger competitors, whether or not you feel like there's been some consolidation happening in the market. I would just be curious to get your thoughts on how is LECO share have been trending more recently and where do you feel the outlook is kind of settling over the next few years.

Yes. Always difficult to kind of talk specifics on market share. But we have been accelerating investment in product development and positioning within our equipment business. You've seen some very good results over the last couple of years quarter-by-quarter on our standard equipment portfolio. We like to measure things like our Vitality Index. And we point to on the equipment side being over 50% of our sales in 2020 in our equipment business, driven by new technologies, new product introductions over the last 5 years. So we do believe that our positioning on the equipment side has been very strong. That does allow us to accelerate areas within the equipment portfolio that we think we're underpenetrated in. And so we look to opportunities to improve our market positioning there. Outside of that, then you have automation is, again, a differentiator in our business model that we think will provide us an accelerated level of growth and also market positioning.

Got it. That definitely makes sense. And then maybe as it relates to LECO in particular, in terms of your own product mix, right? I think you said in the past that LECO's product mix has shifted more towards equipment in recent years. I think, first of all, what would you say drove that change? And is your goal to kind of maintain that mix over time? Or do you feel like there's still room to run in terms of where you see the optimal level of the revenue breakdown?

Yes. So as I mentioned, automation beginning -- being a bigger part of the mix as well as standard equipment and what we've done to position resources on the equipment side, that changes the mix a bit, but nothing intentional to pull back on our focus on consumables. And that's obviously a very key part of our product mix, and we'll continue to drive our position in consumables as well.

Got it. And I guess going forward, are there any margin differences between the 2? I mean we obviously spoke to the implications of the automation business, but does LECO today kind of carry any meaningful margin nuances between OE and consumables that are worth keeping in mind?

Yes. No, I would assume a fairly comparable margin profile between consumables and standard equipment.

Got it. And then maybe just wrapping with a question on capital allocation. You obviously talked about your more aggressive stances towards M&A over the past few quarters. On the buybacks, I think has similarly begun to account for kind of a larger percentage of your quarterly capital allocation as well as historically been important for your capital deployment framework. How would you kind of point investors to think about the kind of cadence of buyback activity into the back half of this year into next?

So I just always want to emphasize that [indiscernible] capital allocation, the first priority is our growth; internal capital investment for product -- new product introductions; capacity needs; acquisitions, which we spent some time talking about, very much key to our allocation of capital. As it relates to share repurchases, I mean, we like the posture with that [ lease ] maintenance, which is around that $50 million level of share repurchases. And then anything north of that is really an opportunistic types of buys. But our primary focus will be in growth. And then again, on share repurchases, maintenance plus opportunistic types of purchases.

Got it. Well, with that, I think we're coming up on the top of the hour. So I want to thank Gabe and Amanda for their time, especially Gabe pushing through the throat. So I really appreciate that.

Yes, Of course.

Yes. No, I definitely appreciate that. So, we'll go ahead and leave it there. Thanks, again, for your time, Gabe.

All right. Well, thank you, Dillon. Nice talking to you again.