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

I'm Dillon Cumming. I'm the machinery and construction analyst here at Morgan Stanley. I'm very fortunate to have with us here today, Lincoln Electric. From the company, we have Gab Bruno, CFO; and Amanda Butler, Head of IR. So guys, thanks for being with us today.

Thanks, Dillon. Nice to be here.

Before we get started, just going to read 1 quick disclosure. 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, Gabe, maybe we can start kind of a near term kind of update on the company. Last quarter, you saw momentum across all of your end markets. Pricing was very strong in the quarter, up 17%. First of all, remind us of expectation -- around the expectations for that level of end-market momentum in the back half, which markets are strongest from a volume price perspective?

Sure. So as you saw, we did increase our organic assumptions for this year into that mid- to high teens -- sorry, with volumes. We're ranking around that mid-single-digit volumes, and we had [indiscernible] increase for the first half of the year in volume. So you could presume in an acceleration in the volumes as we enter the second half. We do begin to anniversary a lot of the pricing actions that we took second half of last year. So that's included in those assumptions. So you see some moderation year-over-year within pricing. In terms of broad markets continue to have very strong backlogs in equipment as well as automation, very strong across the Americas in activity. You saw second quarter, 10% volumes. Almost 20% pricing. So very good momentum to this third quarter. We continue to be cautious on the international segment. You've got European pressures, which is difficult to have good visibility after the traditional summer vacation schedules and shutdowns. So we'll get more visibility as the quarter winds down, but we're cautious. As you all know, there's a lot going on in the European markets, and it does put a lot of pressure and uncertainty in the progression in that market. China has been very challenged, as you know, for the first half of the year. Government incentives stimulus is expected, but still be some time before we see that really take hold. So we're cautious on the international side. On Harris, the one area of Harris that's just been the challenge is the retail and the consumer-driven activity, and we mentioned that through the second quarter. And we expect that to be challenged for the balance of the year. That gives you a big picture. We're maintaining those assumptions, continue to see some acceleration, strength in volumes very strong backlogs, equipment and automation.

Yes. Yes, that was a great overview. And maybe we can just switch the conversation over to margins, right? Last quarter, incrementals around 30%, very strong, towards the high end of your normal operating range. Obviously, in the context of overall operating assumptions for the year, right? You talked about that kind of mid- to high 20% range for the year. So in that context, can you just kind of square off what's embedded in the outlook for the back half of the year?

So keep in mind that as we start to anniversary the step changes that we've experienced in international as well as the automation business that the incrementals will be less robust. I mean we were 30% for the first half of the year. We did increase our assumptions to mid to high 20s. So we do expect to continue to see robust margin profile. When you think about the segments in that context, so continued strength across the Americas, as I mentioned, it ties into the volume, the activity and the end market strength that we're seeing, strong backlogs. On the international side, we'll see pressure on the margin profile. We're starting to see some energy costs and challenges progress there. So we'll have some pressure on margins on the international side as we wind down third quarter, and we'll see how that progresses into fourth quarter. On the Harris side, you mentioned pressure on metals and retail. So we'll see that in this third quarter progress into the fourth quarter, but still strong operating margins, incrementals, anniversarying some of the step changes, we made in international, we'll see that as we progress third quarter, fourth quarter.

Yes. Got it. Maybe we can kind of zoom out for a second. One of the LECO's qualities such a lot different markets, right? And I think at various points over the last year or so, you guys have been pretty convicted that we're still relatively early cycle kind of in the broader industrial complex rate. Has the thinking changed there at all as we've moved through this year? And looking into next year, where are we kind of in the broader cycle of your end markets?

So I'll start back to go back to the volume assumption. So we're talking about being in the mid-single-digit volumes. As we achieve that, we're getting back to 2019 levels, and I'd like to emphasize that because when we think about the international markets back in 2019, particularly Europe, Europe was under contraction pretty much the full year. And when you look at -- think about the Americas, particularly in the U.S., the U.S. began to contract in the middle part of 2019. The markets really were a bit cautious going into 2020 before the pandemic, if you recall that. So we're talking about going back to volumes, activity levels into 2019, which was a soft economic environment from an industrial standpoint. When you go through the end markets though, we see pretty solid drivers to growth. So when you go to automotive, obviously, we talked about inventory levels, supply chain somewhat stabilizing, you've got a long runway to get back to production levels that tie-in to historical, even though the markets may not get back to historical inventory levels from an automotive standpoint, but the fundamentals are strong. Heavy industries, whether it's heavy construction, the impact of infrastructure bills that tie-in to real activity, still strong. Ag, mining still provide good drivers there. General industries, we track, as we all do, PMI and industrial production is relatively stable, and it has been since the middle part of 2020. So we look at general industry is kind of flattening in a stable environment. Energy, some drivers there. Wind is an application of welding that we're pretty excited about. It's got a long cycle for investment, but the renewables tied into also the key drivers around oil and gas are pretty healthy. So we look at energy there. And I think you look at structural infrastructure. When you think about our business, I mean we have -- we estimate that 15% to 20% of our business is exposed to infrastructure and renewables. And those are a lot of investment going in infrastructure and obviously, also renewable. So we're pretty well positioned. So we think it's still early on in the cycle.

Yes, makes sense. And I think I know the answer to this just given your response, but obviously, a lot of kind of concern in the market with regards to potential recession next year. Any parts of the LECO business that are reflecting that today, order trends, et cetera, that might have you more concerned about next year?

Yes. As I talked, I think the consumer side, particularly the retail part of our business that's within Harris, and we're starting to see that. So consumer activity is much different dynamic, although obviously, it has downstream implications on the industrial side. But on the industrial side, we see the strength. Consumer activity could be a pressure point. The geopolitical dynamics around international markets can create a lot of different dynamics, but we'll work through those issues as we see them.

Yes. Makes sense. Maybe if we can kind of switch over longer term. A couple of quarters ago, you guys refreshed your higher standard strategy. You set a couple of new 2025 targets for top line and EBIT across your segments. Can you just talk a little bit about the process, how you got to those targets and what the kind of core strategy entail that you're going to look to refresh that for 2025?

Yes. So this goes back and we set our 2025 Higher Standard Strategy back in the beginning part of 2020 before the pandemic. But as we continue to realize the benefits of the structural changes that we put in place and primarily on the international side as well as the automation side. And then our -- the confidence we have in the growth trajectory in our business, we felt was appropriate to increase the targets. Yes, we have been hitting some of those targets already, but I just would point to remind, when you review our deck -- our investor deck, that we look to an average of 16% on the OP side. So -- and driven by a 200 basis point expansion in our model, that's really what we're thinking about. So on average, we're currently just shy of 15%. And we feel the momentum we have international, the strength we have long term and the drivers around Harris in the markets as well as automation. Automation, that margin profile is progressing very nicely, and it tied -- a large portion of that is in the Americas segment. So we're progressing very much on target. So we're excited about where we're at. We just up the targets. And while it looks like we hit them already, we're navigating the cycle -- we're navigating the challenges and looking for an average through the cycle for the full period in our margin profile.

Yes. Got you. And you kind of alluded to this in some of your earlier comments, but just with regards to the European energy, electricity cost situation, right, a lot of volatility, concerning about gas availability, et cetera. What have you seen on the ground from your footprint in terms of impacting production footprints or just overall kind of cost inflation as a result of some of those gas and electricity inflation challenges?

Yes. So we're seeing, for sure, the escalation energy costs and that's across the market. And it's difficult to assess what the activity will look like because we're just coming off the lockdowns, still early, middle part of September. But I'll tell you, there's a lot of caution. Energy rationing the implications to people and companies and just a lot to be done. So we're doing our business continuity planning. We're looking at how do we respond to the various challenges. We look to inventories and our demand planning practices to give us visibility, but there's a lot of uncertainty. And I think the fall season, how the various countries posture for conserving and rationing energy is going to be very important. So we just got to stay real on top of it, but a lot of uncertainty still.

Yes. Any like direct impact of vertical in terms of not being able to produce a getting gas flows there?

No. Short term, we've got our factories ready to produce and to also balance out the load, but I think it's too early to tell. I think the fall season will give us a better sense of how rationing has an impact to real industrial activity.

Yes. Got it. Moving on such over to automation. Obviously, a very strong secular theme for the company over the long term. You've got the target for about $600 million this year, moving to $1 billion as part of that refreshed higher standard strategy. Can you just talk about the path of it -- path to get there? Is that organic M&A, what you guys are doing to achieve that $1 billion target?

Yes. So we're very excited about automation. We're tracking over $600 million this year with record backlogs coming into the third quarter, and you see the continued step pacing we have within that $400 million 2020, $500 million about 2021, $600 million plus million this year. It's going to be driven by organic growth as well as acquisitions. We've been very focused on our strategy on and looking for opportunities on the acquisition side. Organic growth being at the high single digits, low double digits, which is less than what we're seeing now, but that's a good tempering to think about the long term. We feel that's going to be an accelerated level of growth. So half of that incremental will be through organic growth, half of it will be through acquisitions.

Yes. Got it. And when we think about things like onshoring, reshoring, I think I've asked you guys probably for each of the past couple of years you've been doing the Laguna conference. But are you really starting to see that theme materialize in the order book at this point? Because it feels like we're seeing more evidence of companies bringing manufacturing back of the states and given the labor situation, right, those conversations feel more need based. So is that consistent with what you're seeing as well?

Yes. We still hear that theme. It's kind of hard to specifically pinpoint that this investment and capacity was driven by onshore and reshore, but we do have that theme continuing. And I do believe that's going to be a continued theme considering all the global supply chain challenges that we've seen and experienced over the last couple of years. So we do believe that there will be more investment in capacity and their automation offering does show up some of the needs and labor to be able to counter that. So we think that's a good driver, a tailwind for further investment in Americas.

Yes. And can you just remind us what the mix of the business is between nonauto and auto? Because it feels like there's more of a shift going on away from auto kind of in the current cycle as well. So is that consistent with what you've been seeing in terms of more recent order trends.

Well, the automotive end market is still very strong. So I want to say, we're shifting away from that, but definitely want to be more balanced in the portfolio of customer activity. So just a couple -- a few years ago, we would have said, we're about 50% automotive, right? Now we're about 1/3, and that's pretty intentional. We had some acquisitions in the past that were anchored around the appliances, general industry. We introduced Cobots middle part of last year that accelerated the level of adoption and simplifying the ability to use a robot on a factory floor that ties into the small and midsized fabrication. So very intentional to balance out end markets, but automotive investment is going to continue to accelerate, particularly with EV progressing. So we're about 1/3 now automotive, but a third general industry and 1/3 heavy industry, structural automation. Our acquisition last year, we did it back in Austria, tied into structural automation fabrication. So a very good balance.

Yes. Got it. And you mentioned Cobots, I think it's been a pretty recent innovation for you guys. Can you just talk about how your strategy on the automation front differs from some of your larger competitors as well because I do think you guys have a bit of a differentiated strategy.

We're much more invested when you benchmark our business with the other bigger players in the industry, and this has been long standing. I mean we started years ago about into robotic cells and it just progressed in building out capabilities. So while we're tracking $600 million, some of our competitors talk about adding $100 million to $150 million incremental business, and we're targeting $1 billion. So it just gives you a sense of the magnitude of our investment base and where we're targeting strategically in automation.

Yes. Makes sense. And can you remind us why the business has been more historically Americas focused? I'm guessing it is more a function of the auto exposure. But when you think about kind of the next leg of growth, obviously, you did the international acquisition last year, is this business going to be more international focused over time and a better point of emphasis going forward?

Look, it's certainly an opportunity for us, and we do look for those opportunities. There are structural differences. Many of the large OEMs have many of their embedded engineering capabilities to do their own automation on that. So -- and the fragmentation in the U.S. markets have allowed us to build on the capabilities that we have, but we do look at international markets as being opportunities. We do have presence throughout the international markets, but as you mentioned, our large presence is in the U.S. and the Americas. And that will continue to be a strong footprint, but we'll look for opportunities to continue to accelerate growth.

Yes. Makes sense. And then last question on the automation side. The margin profile has been point of debate, let's say, over the last few years. It seems like you've had some really good traction on that front over the last year or so, but historically, the business has been bumpy, right? Can you talk about some of the actions you've taken to improve the margin profile there? What the scope is they're going to trend at or above the corporate average over time?

Yes. So if you think about all the acquisitions that we had done leading into 2020, we had put forth the plan on how did we build on a more cohesive business unit versus a fragmentation of different companies. And we've put in what we call a Lincoln Business System that tied into some key processes. We've built our business around a commercial strategy that's unified, operational strategy that's unified, back-end processes and our shared services. And so that has allowed us to take fragmented businesses, and we were tracking into that mid- to high-single-digit EBIT to establish a target of 2x that to doubling the EBIT profile of automation. And so with the growth, with the business process improvement that we've driven, we're not tracking the low double digits. So you compare our business this year, even last year, we had about a 50% improvement in the EBIT profile, and we're right on track to our target to be at the corporate average.

Yes. Good to hear. Maybe we can pivot the conversation over to M&A, right? I mean LECO has been historically pretty equal to the company, and you've definitely shifted to a more front footed, I'd say, past over the last few years as well. Can you just talk about some of the more recent acquisitions that you've made, the capabilities they brought and then thinking about the next leg of opportunities, how the pipeline is shaping up today?

Yes. So you see in our strategy, go through our deck, we're targeting that 300 to 400 basis point CAGR on sales growth through acquisitions, and that has been a consistency across our business. The targets that we look to are aligned to how our segment teams are working with our corporate teams to build out capabilities across the segment. So you can look at the last couple of years. You saw acquisitions in Harris. You saw transaction international. We just had one in Americas in the first quarter, and they're either automation or tied to our core welding or brazing businesses that allows us to broaden our footprint. So it's a very active part of our strategy. It's disciplined -- very disciplined and looking to a coordinated effort between our corporate strategy team and our segment teams to identify and work through what makes sense for us. We're going to be very disciplined to overpay. We're going to be very balanced in how we value the businesses, but they got to tie into our core strategy, and we're consistently performing at that level.

Yes. Makes sense. Maybe switching over to kind of pricing and price cost, right? I mean, as I kind of alluded to at the beginning, it's been a pretty notable standout over the past few quarters that those kind of mid- to high teens levels. In terms of how it's been trending across the core welding segments, how effective have those cost increases? Or how those price increases been at offsetting all the inflationary factors that have been impacting the business?

Yes. We have a long-standing discipline in price/cost. Our posture is to be price/cost neutral at a margin level, and our teams understand this. So very disciplined visibility in terms of looking at cost current, what the forward-looking view is and our teams understand they need to be price/cost neutral. So we're very effective in managing that, and we've got a long-standing position. We continue to operate, as we all know, in an inflationary environment. They get a lot of questions on steel. Steal is one component. Now we're dealing with an acceleration of energy. So we need to just continue to be very disciplined and our teams will be.

Yes. I guess if we think about the industry more broadly, right, have you seen any evidence of more disciplined behavior from the competitive side? Or has the industry been pretty rational kind of in the current environment, do you say?

It's been largely rational. The velocity of change in cost -- when companies are not disciplined on that, you're going to see immediate impact. So I think the market has been largely rational in looking at price cost.

Yes. And then when you think about the overall kind of cost complex outside of kind of core materials, but the overall state of your supply chain, right, how has that been trending in recent quarters? You've seen improvement in component availability, labor, things of that nature?

Yes. So from a labor, I'll start with labor. Labor has been relatively stable now. We have -- we always have the natural manufacturing turnover, and we've hit our targets. We're going through a dynamic of training and development some of our newer employees on that. So you have that dynamic. When you think about cost and supply chain broadly on our consumable side of our business, which is about 58% of our business, we're seeing more stability. But when you're dealing with the complexities of our equipment, the components, we're still dealing with supply chain challenges, and we're not out of the woods yet. So we're managing it, and we have our engineers, our engineering team very actively involved in looking at material substitutions and ways to minimize any disruption from a customer standpoint. So getting better on the consumable side, still some challenges on the equipment side.

Yes. Got it. And I just want to spend some time on the International segment because you mentioned, right, it's been a huge growth story for the company on the margin side in particular. When we think about the progress made year-to-date even, right, what has that been reflective of outside of volume leverage? Is it more a function of putting more throughput through a more profitable footprint? Or how would you kind of characterize that margin improvement year-to-date?

Right. It's less about the volume, it's more about all the structural activity we've done over the last years, and it continues. So if you just go back and give you a quick comment, the Air Liquide welding acquisition put a lot of pressure on us on the integration work, and it touched very -- every aspect of the business model, whether it was our commercial strategy, the product lines, the manufacturing footprint, back-office processes. And just a lot of efforts in thinking through what the appropriate business model would look like. And so you saw as we enter the middle part of 2021, a lot of the maturing things were coming together on that and really taking us to where we wanted to be at double-digit EBIT. And you continue to see that growth and development within the model. So we're pretty excited about where we're at. We'll continue to need to navigate through the ebbs and flows of particularly European markets, but we're pretty excited about where we've the business model. That's why we increased the targets to 12% to 14%.

Yes. Makes sense. I guess when you think longer term, is that a segment that can never reach Americas like margins? Or are there more structural kind of like [ Capson ], how close can kind of get to closing the gap?

Well, there definitely are structural differences between the Americas and international model. The Americas has a larger variable cost structure with the incentive structures we have on the Americas side. Our footprint, the brand and the leading position we have in the Americas segment also has an impact to the position. I think the targets we have established give you a differentiation there. That is part of our model. We'll continue to look for opportunities to shape and improve margin position because that's in our value and our value is this continuous improvement, but that structural difference exists. And so I think what the targets we have are representative of where we think the business model is currently.

Yes. Makes sense. I wanted to ask about a release you guys put out a couple of weeks ago, which I don't think many of us were expecting. It was on the DC fast charging initiative that you announced. I'm not sure that was the next -- one would thought you guys would do, but I mean it was interesting to see, right? And you mentioned that you were leveraging a lot of your core competencies. You've had manufacturing capabilities in place. Can you just talk about the industrial logic of why you're entering that market? What kind of core competencies like lend you to believe that you're going to have to position in that market?

It's interesting. If you go back to our history, there's an old Lincoln book that talks about electric vehicle over 100 years ago that was developed by one of our founders. And what's in the dynamic there is that -- I mean we're an electric technology company. So we understand what develops the power, the energy to be able to well. And so when you think about power electronics, the ability to develop charging capacity, it fits right within our capabilities. So we're leveraging our capabilities in the market that we all know is significantly amount of investment going into and for the long term. And I like to think about how we're now participating in the growth agenda. So you have the welding components, right? Every vehicle, whether you compare internal combustion to an EV vehicle, we look at that as a push in terms of the actual welding content. When we're talking about automation growth in automotive, significant amount of investment in capacity, and so we're planning into that from an automation standpoint. And then when you look at battery charging needs and significant amount of opportunities. So we're looking to develop a position there and see how we can leverage our own capabilities in power electronics and understanding the technology to be able to go there. I gave you a data point that I find interesting. So I understand there's about currently 5,000 charge points in the U.S. market. The administration with all the incentives are talking about, I understand about 500,000. And there are studies that talk about a need that's over 1 million. So it tells you the order of magnitude of the market and how it's going to be developing in the years to come, and we think we've got many avenues to participate in the high-growth opportunity here. So we'll see how it plays out. We have the capabilities. We need to develop partnerships. We want to be able to commercialize this opportunity by the first half of next year and be in production back half of next year. That's how we think about it.

Got you. And when you think about that kind of early stage manufacturing ramp, are we kind of talking in terms of millions in the early stage moving up over time? Or how should we think about the magnitude of the opportunity?

That's to be defined, but we have capacities to be able to serve growth. And depending on how we see a level of acceleration, we'll posture to be able to meet demand.

Yes. Got you. I do want to ask about Harris as well because as you mentioned, right, the part of the business that's more exposed to the retail channel, right, might reflect those more recessionary concerns. Can you just talk a little bit about how that business is performing versus your kind of other core welding segments year-to-date? And what you're kind of expecting over the near term or the back half as well?

Yes. For Harris, I mean the core business is strong. Retail will continue to be weak. We are going to have challenges. We talked about on the metal side, and that will -- we'll see that more so in the third quarter. We'll be able to address that and move on for that, but Harris is a very strong business model. We're very satisfied with where we are at, currently in that 13% to 15% long-term target for Harris and EBIT. We'll have some short-term dynamics in metals and retails, but very well positioned. The acquisition we did last year tied to HVAC. A lot opportunities in HVAC still in the market and seeing some growth dynamics potentially into next year. So we're pretty excited about our position at Harris as well.

Yes. So going that commentary, I guess, floating growth next year. You're not anticipating any kind of like cliff risk in the business because that is, I think, fair case a year sometimes that the business has outperformed through COVID and maybe there's more of a [indiscernible] to come.

Yes. The biggest challenge currently we're kind of dealing with is the retail side. When is that truly stabilized and then you see the consumer level activity monitor, so we'll continue to see pressure there. Short-term dynamics on metals with all the volatility you've seen and how that's repositioned, but the model is very strong.

Got you. We got a couple of minutes left so I'll open it up to the audience, see if there are any questions. Just I want to ask a question on capital allocation as well. I think buybacks, right, is similarly accounted for a larger percentage of the overall pie in recent quarters. How do you think about the cadence of buybacks both from the back half of this year and next year as well?

Well, look, we're pretty balanced in looking at capital allocation. We want to make sure we're prioritizing growth. So we have upped the level of internal investment, CapEx. We also are very much looking for continue to drive our acquisition agenda. We continue to -- we have a long-standing position of increasing dividend rate. So we've got that dynamic. And then we want to make sure we cover maintenance, and we're opportunistic in terms of share repurchases. So we don't have a hard and fast target on share repurchases. You saw that we -- by the way, the maintenance level is $50 million to $60 million in the year. We repurchased shares at $130 million for the first half of the year. So that will continue to be our posture be opportunistic in looking at share repurchases.

Yes. Makes sense. I got a question on market share maybe. I think taking back to the last cycle, you had a larger competitor that was vocal about going after more 80-20 strategy, right? Kind of seeding some more margin dilutive share of the market, if you want to call it that. How is your own market share trended in recent years? How do you approach that kind of dynamic over the last cycle?

Yes. So we look at difficult to always measure, right, [indiscernible] market. But we believe that more of the regional -- we've positioned for growth. We're accelerating automation. We have done work on the SBUs. We have what we call strategic business units that are really tied to growth areas in our business. We think we've done a nice job there, particularly on the equipment side of our business. But we think that the market has been relatively stable amongst the big 3, taking some share I made from the regional Tier 2 players, but we feel that our positions continue to be pretty strong.

Yes. Got it. And then just last question for me. You've said in the past, I think that Lincoln's revenue mix, right, shifted more towards equipment in recent years. I'm guessing some of that was considerable change in automation, but how do you think about the next kind of leg of product mix shift over time? Are you expecting to stay stable? Or how would you characterize that?

Well, you're going to see a higher mix on the equipment side because of the automation. So we're right now about 60-40 split. We see opportunities for growth in standard equipment accelerated as well as into automation. So you'll see a little bit more shifting in the equipment side of our business over time.

Got you. look, we're at the top of time. So Gabe, I appreciate the time. Thanks for coming out.

Right. Thanks, Dillon. Nice talking to you.

Likewise, yes.