Allegion plc (ALLE) — Q3 2020 Earnings Call Transcript

Thank you, Andrew. Good morning, everyone. Welcome and thank you for joining us for Allegion's third quarter 2020 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slide number two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our third quarter 2020 results, which will be followed by a Q&A session. For the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then re-enter the queue. We would like to give everyone an opportunity given the time allotted. Please go to slide four and I'll turn the call over to Dave.

Thanks, Tom. Good morning and thank you for joining us today. I'll start by walking through the third quarter financial summary. Revenue for the third quarter was $728.4 million, a decrease of 2.7% or 3.4% organically, which shows sequential improvement from Q2 to Q3. The organic revenue decrease was driven by continued economic challenges stemming from the COVID-19 pandemic. Currency tailwinds provided a boost to total revenue and more than offset the impact of divestitures of our business in Colombia and Turkey. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 20 basis points in the third quarter. I'm extremely proud of the resiliency shown by the Allegion team. We executed extremely well and the cost management actions taken during the year helped mitigate the deleverage from volume declines. Positive pricing and muted inflation also helped deliver the operating margin increase. Adjusted earnings per share of $1.67 increased $0.20 or approximately 14% versus the prior year. The increase was driven primarily by favorable other income, tax rate, and share count offsetting the lower operating income. Year-to-date available cash flow came in at $256.1 million, an increase of just over $26 million versus the prior year. Improvement in working capital and reduced capital expenditures more than offset the lower net earnings. Please go to slide five. Access has been part of our company's heritage for more than a hundred years, and our vision of seamless access and a safer world provides a sound foundation for our future. In the realities of a post-COVID world, customers have new concerns and new needs for healthy environments. The importance of making homes, workplaces, and institutions safer has never been so significant to our customers, and the needs for touchless access are not going away. Our business is disciplined and focused, prioritizing investments in our seamless access strategy. As a result, Allegion continues to deliver leadership and innovation across the portfolio. Our Schlage brand is a hundred-year-old powerhouse that spans the globe. In the building channel, our mix of Schlage mechanical and electronic solutions continue to help us win projects, including a new development community in Florida with over 3000 homes. Allegion is further advancing seamless access for builders with electronic solutions that provide contactless home showings, and the Schlage Encode Smart Deadbolt continues to gain momentum in both residential new construction and retail markets. On university campuses, among the first schools to adopt Schlage security solutions for Apple Wallet are the University of Tennessee, University of Vermont, and the University of San Francisco. Allegion now supports contactless student IDs across Apple Wallet, Android, and Google Pay. For commercial and institutional markets, we have a full suite of mobile-enabled Schlage locks and readers. In a post-COVID environment, mobile technology, contactless hardware, and readers in combination with wave-to-open actuators now extend our touchless options for interior and perimeter security. Seamless access is also gaining traction outside the Americas in Q3. SimonsVoss is celebrating its 25th year as an electronic access innovator and was recently recognized in Germany as the number one electronic locking system manufacturer. In Australia, we just delivered the Gainsborough Freestyle Electronic Trilock for single family and short-term rentals, giving the owner full control of access from a mobile app. And in Australia and New Zealand, we introduced the Schlage Omnia fire-rated smart lock for multi-family and office settings. In the quarter, we booked over $4 million in orders to support and provide seamless access touchless solutions to a global leader in social media to be delivered in 2021. Our investments in seamless access are bolstered by global accelerators. Allegion's partner of choice and open credential strategy is an important accelerator. More than 45 physical access control software providers already integrate with Schlage electronic locks and devices. Many of them are moving to integrate into our mobile credential ecosystem as well. Our global accelerators include e-commerce, touchless access, and increased focus on visitor management and occupancy monitoring. Seamless access is proving to be a strong foundation for our future. Patrick will now walk you through the financial results, and I'll be back later to discuss our 2020 outlook and wrap up.

Thanks, Dave. Good morning, everyone. Thank you for joining today's call. Please go to slide number six. This slide reflects our earnings per share reconciliation for the third quarter. For the third quarter of 2019, reported earnings per share was $1.40. Adjusting for $0.07 for prior year restructuring expenses, integration costs related to acquisitions and debt refinancing costs, the 2019 adjusted earnings per share was $1.47. Favorable other income and interest expense increased earnings per share by $0.15. The increase was driven by an approximately $14 million non-cash currency translation gain related to the liquidation of a legal entity in our EMEA region. This benefit would not be expected to recur in 2021. Favorable year-over-year tax rate and share count combined to provide another positive $0.08 per share impact. Operational results decreased earnings per share by $0.03, driven by volume deleverage that was nearly offset by favorable pricing and productivity exceeding inflationary impacts, as well as favorable currency. This results in adjusted third quarter 2020 earnings per share of $1.67, an increase of $0.20 or approximately 14% compared to the prior year. Lastly, we have a $0.09 per share reduction for charges related to restructuring and impairment costs. After accounting for these items, you arrive at the third quarter 2020 reported earnings per share of $1.58. Please go to slide number seven. This slide depicts the components of our revenue performance for the third quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced a 3.4% organic revenue decline in the third quarter. The COVID-19 pandemic continued to impact the top line number, although we realized the benefit of delayed projects from the prior quarter. As shown in the trending chart, revenues rebounded nicely, but were short of the very strong quarterly results in the prior year. Despite the difficult and uncertain times we are operating in, the overall business performed very well, particularly in the supply chain and meeting customer requirements. It is also important to note that pricing remained solid in the quarter, which slightly offset the volume pressure. Currency also provided a tailwind to total growth and more than offset the impact of the divestiture of our businesses in Colombia and Turkey. Please go to slide number eight. Third quarter revenues for the Americas region were $539.1 million, down 5.1% on a reported basis and down 4.6% organically. The decline was driven by volume challenges in the non-residential business due to the COVID-19 pandemic and was partially offset by good price realization and strength in the residential business. The non-residential business was down low double digits. Conversely, residential bounced back nicely and grew at a low double-digit rate. The Americas electronics revenue declined in the mid-single-digit range, as discretionary commercial projects are delayed. We see electronics and touchless solutions continuing to be long-term growth drivers and expect electronics accelerated growth to resume when market conditions normalize. America's adjusted operating income of $166.6 million decreased 5.1% versus the prior year period, and adjusted operating margin for the quarter was flat. Discretionary cost actions, restructuring benefits, and material deflation mitigated the impacts of volume deleverage and unfavorable mix. Please go to slide number nine. Third quarter revenues for the EMEA region were $148.4 million, up 7.7% and up 2.9% on an organic basis. The organic growth was driven by strength in the Global Portable Security and SimonsVoss businesses, as well as solid price realization. Favorable currency impacts contributed to total revenue growth and were slightly offset by the impact of the divestiture in the business in Turkey. EMEA adjusted operating income of $17.1 million increased 42.5% versus the prior year period. Adjusted operating margin for the quarter increased by 280 basis points. The margin increase was driven primarily by pricing and productivity exceeding inflation. Productivity was bolstered by benefits from lower operating costs from the restructuring actions taken earlier in the year, as well as discretionary and variable cost reductions. Please go to slide number 10. Third quarter revenues for the Asia Pacific region were $40.9 million, down 4.2% versus the prior year, with an organic revenue decline of 6.8%. The decline was driven by continued COVID-19 related impacts and weakness in Korea. Our Australia business performed quite well despite the ongoing pressure in Australian end markets. Currency tailwinds offset some of the organic revenue decline. Asia Pacific adjusted operating income for the quarter was $3.2 million, a decrease of $1.2 million with adjusted operating margins down 250 basis points versus the prior year period. Of note, the prior year operating income includes a $1.1 million favorable one-time item related to the recovery of previously remitted non-income taxes. This had a 260 basis point favorable impact on Asia Pacific margins in Q3 of 2019. Excluding that, margins were essentially flat year-over-year, with the volume deleverage and unfavorable mix being offset by favorable pricing and productivity exceeding inflation. Please go to slide number 11. Year-to-date available cash flow for the third quarter 2020 came in at $256.1 million, which is an increase of just over $26 million compared to the prior year period. The increase was driven by improvements in net working capital and reduced capital expenditures, which more than offset lower net earnings. Our strong cash flow generation has been an asset to the company. This was evident in the third quarter and will continue to serve us well during the current market environment. Looking at the chart to the right, it shows working capital as a percentage of revenues decreased based on a four-point quarterly average. This was driven by reduced working capital needs from the lower volume, as well as strong collections performance. The business continues to generate strong cash flow and we remain committed to an effective and efficient use of working capital. We will continue to evaluate opportunities to optimize working capital and drive effective cash flow conversion. Please go to slide number 12. Our financial and liquidity position remains extremely solid. Our net debt to EBITDA ratio is 1.6, based on the last 12 months' performance. Our debt covenants are well within the required limits. And we have no near-term debt maturities. Our $500 million credit facility remains untapped. Our quarterly dividend in 2020 increased 18.5% through the third quarter. This is the sixth consecutive year of annual increases. In addition, with strong operational execution and cash generation, the increased cash position since the beginning of the year, and better visibility into business conditions, we have resumed share repurchases under our previously authorized $800 million program. As you have heard us say numerous times, we've put our excess cash to use as part of our commitment to a flexible and balanced capital allocation strategy. I will now hand it back over to Dave for an update on our full year 2020 outlook.

Thank you, Patrick. Please go to slide number 13. As you know, we were one of the handful of companies who provided an outlook following Q2. With another quarter behind us, and a bit more clarity, we are updating our outlook for 2020. In the Americas, we expect continued pressure on the non-residential business, as discretionary spending and commercial markets remain tough due to people continuing to work from home. In institutional markets, the projects that are restarted will continue to finish. The rate of completion may be slowed due to restrictions on the number of people on job sites and supply chain issues at the construction site. Residential markets are expected to remain strong in all channels we serve: big box retail, e-commerce, and new construction. With these expectations, we are improving the organic revenue outlook in the Americas to be down 5.5% to 6% for the full year. We are projecting America's total revenue decline to be 6% to 6.5%, with a slight impact from the divestiture of the business in Colombia. In Europe, we saw sequential improvement in Q3 and we expect Q4 to be better than the year-to-date performance we have experienced. For the region, we now project organic revenue to be down 6.5% to 7.5%. Total revenue includes currency tailwinds in the latter part of the year, as well as the impacts from the divestiture of the businesses in Turkey and is projected to be down 4.5% to 5.5% for the full year. In Asia Pacific markets that were weak before COVID-19, especially in Australia, we expect that along with the weakness we are experiencing in Korea to continue. With this backdrop, we expect a 2020 organic revenue decline of 12% to 13%. For 2020, total revenue is expected to be down 12.5% to 13.5%, with a slight impact from currency. We are projecting total and organic revenue for the company to be down 6% to 6.5%. We are raising our outlook for adjusted earnings per share to a range of $4.75 to $4.80. Although net investments are assumed to be relatively small in the revised outlook, we remain committed to investing in innovation that supports our seamless access strategy. This outlook reflects the reprioritization of investment to support the expected future of electronics growth. Our revised outlook assumes a full year adjusted effective tax rate of approximately 13%, as well as outstanding weighted average diluted shares of approximately 93 million. The outlook additionally includes approximately $1.30 to $1.35 per share impact from impairment and restructuring charges during the year, most of which have already occurred. As a result, reported EPS is estimated at $3.40 to $3.50. Finally, our revised available cash flow outlook for 2020 has increased and is now projected to be in the $400 million to $420 million range. Please go to slide 14. Allegion has strong business fundamentals and a proven ability to execute and adapt to changing and uncertain market conditions. We have managed the business extremely well to mitigate the impacts of the ongoing pandemic. We remain ready to serve our customers and meet their needs for touchless access and healthy environments with our market-leading brands. We will provide an official outlook for 2021 during our Q4 full year call early next year. But as we think about the remainder of the year, and begin to look at 2021, some key observations that we see are that, as previously expected, commercial and institutional markets will continue to be soft in Q4 and in the first half of 2021, with a snapback in repair, retrofit, and small projects beginning in the second half of next year. US state and local bond issues continue to move ahead and are supported by local communities. Residential end markets are expected to remain strong for the long term, as an under-supply of single-family homes is corrected. We will continue to manage our cost base to help aggressively mitigate any volume reductions. Seamless access software and electronics will drive growth and continue to be among our top investment priorities; they are our future. Strong cash flow generation will remain a focus with capital deployment to enhance shareholder returns. Going forward, Allegion will be leaner and more focused as we navigate the coming months and emerge from the pandemic. We have implemented restructuring actions during the year that have addressed the cost base in order to right-size the business. We will continue to evaluate the business going forward and make necessary changes. Our execution and commitment to driving solid results will remain high. In closing, Allegion’s future is bright. We thank you. And we'll now take your questions.

Thank you for the question. Could you unpack the Q4 guidance a little bit? Specifically, as it relates to the residential and non-residential piece in the Americas?

So we don't provide specific guidance by quarter; you can obviously back into that relative to our full year guide. I would say, based on our Q3 performance, strong, both in terms of top line and operating income margin performance, relative to the backdrop of what's going on around the globe. You can see similar types of patterns, in terms of both the non-residential and residential businesses in what you saw in Q3. However, we'll continue to manage the costs to help mitigate any shortfall relative to the non-residential business and the margin impact. We do have a mix impact that's occurring here relative to growth in residential and softness in the non-residential business.

Appreciate that. And then just following up on the residential piece, I understand your comments about the residential new construction cycle picking up, given the low household formations for a long time. But can you provide an update on how the restocking cycle is going? Has that restocking cycle fully been realized at this point? What kind of runway do you see for growth just on that end?

I would say, as we look at the residential segment and the pause taken by all suppliers in Q2, we're at record backlogs, and normalizing that will take into early Q2.

Thank you for that color. Very much appreciate it.

Hey, thanks. Good morning and nice quarter.

Thank you.

So first off, America's electronics revenue down mid-single digits is a significant improvement. You mentioned that the trend of touchless access is real and happening. Do you expect this business to turn positive in the fourth quarter? Will electronics provide some offset to weaker underlying commercial trends in 2021 or is that a bit of a reach at this point?

Electronics will be positive in Q4. As you look at the year, our electronics, especially electronics, mirror our residential and commercial performance. Residential electronics are extremely strong, and somewhat muted in commercial and institutional. The strength in residential electronics is driven by supply chain strength and a strong position in the portfolio of our products. The Schlage Encode, the Schlage Connect, and our KPL locks are some of the best products on the market. There was growth in the quarter despite a supplier affected by COVID. The demand did not stop; it affected our ability to fulfill, and if you normalize that through the balance of the year, our growth in electronics, led by residential, continues, so I feel good about that.

That's super helpful. Thanks for that. And then I want to follow up on the Q4 guidance. It seems to imply America's revenue down mid-single digits year-over-year, with flattish margins, just like this quarter. Why is there not more improvement in the Americas business in Q4?

I would characterize it this way: entering Q3, we had stronger backlogs, particularly in the non-residential business. Some of the projects were delayed, which allowed us to operate more efficiently from a manufacturing perspective; that helped the margin profile and the business. In Q4, there may be a stronger negative mix component relative to the residential and non-residential sales in the quarter, as well as within the channel and product segments of the non-residential business. Many factors are at play, but we will continue to manage the margin well. I was pleased with the progress we made relative to mitigation on the cost side, and you saw that with strong overall margin improvement relative to the prior year.

Yeah. Thanks. I’ll pass it on.

Hi. Good morning, guys.

Good morning, Josh.

Dave, just coming back to some of your comments on the channel replenishment necessary in the residential segment. You mentioned some interruptions on the electronic side that capped fulfillment. Would you mind quantifying how big of a replenishment still needs to happen? How many weeks of inventory or points of demand are needed to return to normal levels in the residential side?

As we leave Q3 with record residential backlog, normalizing that pushes us into Q2. It's not inhibited by our ability for throughput; we have expanded capacity of our residential capability significantly. Demand is good, and we have picked up builders, expanding space at big box retail. E-commerce remains extremely strong. Our ability to keep our customers supplied has built that backlog. I believe we're gaining share with a strong suite of electronics enhancing our position.

Got it…

I'd add that Allegion’s ability to flex that supply chain is impressive, as impressive as anything I've seen in my 40 years of manufacturing.

Got it. Appreciate that color. And then just a follow-up. Dave, I appreciate that you’ve been cognizant that the current environment doesn’t support an optimal 2021 for non-res markets, which is now much more apparent. How do you feel versus your earlier observations, especially with some of the bond issuance commentary seeming more supportive?

Barring a rupture, I believe we're lifting off the bottom. I'm encouraged by the ABI lift from 40 to 47. Spec levels are slightly lighter than last year, which is a net positive. However, I must be cautious, as key markets like commercial and institutional focus on keeping people safe, socially distanced, and managing capacities. The small projects, break-fix, and preventive maintenance that were delayed will become visible as COVID winds down in Q2, and things will return to normal as we approach ‘22.

Got it. Great color. Thanks, Dave.

Thanks. Good morning, everybody.

Good morning.

Hey, Dave, I hate to harp on the Q4 commentary, but I want to make sure I understand it, particularly in America. It sounds like on the residential side, things are very strong. So, the implied step down in Q4, is that just indicates that non-res is going to worsen in Q4 compared to Q3? Any color intra-quarter on trends in non-res would be helpful.

Getting back to Patrick's comments, the slowdown or shutdown in Q2 set us up for a nice backlog to draw from in Q3. We did a good job with that. However, primarily commercial institutional demand has softened, and we see that in Q4.

Okay, great. I appreciate the clarification. And then a follow-up question regarding your visibility into 2021. How do you feel about your existing backlog versus 2022? What is left to complete heading into next year?

In 2021, I mentioned spec writing and incoming order demand, especially related to projects and the backlog. Incoming project quotes remain muted. The backlog is slightly in the low range, but not unhealthy. We would typically approach this time of year with a softer backlog, but we still anticipate some weakness from our previous observations.

Okay, great. Thank you.

Hi, good morning.

Good morning.

Maybe just moving away from the top line for a second, can you describe the fixed cost savings into next year and any major moving parts that could affect margins?

I would characterize it this way. We outlined an $80 million cost reduction target for 2020, focused on discretionary, variable, and structural permanent cost savings. We've identified measures that will help us into 2021, resulting in carryover benefits in the first half of the year that will help mitigate some of the variable components that may return next year. While we're looking at those independently, we’ll continue to evaluate our cost structure and adjust as necessary.

Very helpful. Thank you, Patrick. My follow-up relates to cash usage. Can you talk about share buyback timing and how attractive M&A opportunities are currently?

Regarding M&A, we are actively evaluating opportunities to expand our product or market presence and looking at assets that enhance our technological capabilities, particularly around connectivity and seamless access. However, the current market has fewer assets available. Therefore, we shift more focus toward shareholder distributions; we are in the market to continue putting cash to use for the benefit of our shareholders, enhancing shareholder returns.

From an M&A position, our dry powder and firepower are enviable. We're leaning towards electronics and software that accelerate and add capabilities to our value proposition.

Hi, guys. Good morning.

Good morning, Andrew.

I want to dive into institutional markets, specifically education and healthcare. Regarding education bond issuance year-to-date, how much pressure is the education sector under? And for healthcare, have conversations shifted significantly that allow for getting back to normal? What are your insights?

On the educational side, I find it generally optimistic. as I've spoken to university presidents, their capital projects continue moving forward with state and private funding. However, small projects and preventive maintenance remain sidelined as facility teams are overwhelmed. In healthcare, I see the opportunity, but hospitals are under severe strain, necessitating investment that will take place in the second half of ‘21 and into ‘22.

As a follow-up, can you discuss your market share in the discretionary retrofit market? Are you continuing to do well?

We continue to execute effectively in discretionary spending, working closely with our wholesale partners. A large partner recently shifted completely to Allegion, positively impacting our share.

Hey, good morning, guys. Nice job on the margins. Any changes in how you guys think about pricing going into 2021?

We've had solid performance in Q3 and year-to-date 2020. We'll continue to push pricing and remain competitive in the market. However, we anticipate some inflationary pressure associated with input costs on commodities, such as steel and aluminum. We aim to adjust our pricing strategies accordingly while remaining competitive.

Okay, sounds good. Thanks, guys. Good luck on the rest of the year.

Thank you.

Hi, good morning.

Good morning.

I want to revisit your comments on the snapback in repair and retrofit activities that you're anticipating next year. Are you seeing customers making touchless upgrades in the latter half of this year, or is it still more of a conversation for future projects?

We can identify projects and early adopters, but the momentum for those projects will pick up once we surpass COVID. Unless there's a burning need, the enhancement of infrastructure to touchless is a larger project that is prudently avoided during these tough times.

Got you. That makes sense. Thinking about your position in the reader product, has it become a more essential part of your offering in this seamless transition?

Readers are important but serve as an accessory in the transition. Our real goal is to eliminate the need for a physical card and shift that functionality to mobile devices. This transition will provide enhanced security and greater levels of access management.

Great. Appreciate that color, thank you.

Hi. Good morning, all.

Good morning, Deepa.

Hey, great quarter, by the way. Can you elaborate on the momentum in products that drive your post-COVID operations? Why would you not see continued tailwinds into early next year?

You need to contextualize the environment within a college campus or hospital. The priorities have shifted to immediate needs, cleaning surfaces and managing safety, rather than infrastructure upgrades which are sidelined until circumstances improve. We'll see more movement in the second half of the year.

On the margin profile, electronics maintain similar margins to traditional mechanical products but typically at a higher selling price, leading to enhanced EBITDA. Our growth in electronics will significantly benefit earnings growth.

Great. Thank you for the color.

Hi, good morning. It's Colton, on for David. Congrats on a good quarter.

Thank you.

Can you walk us through how the residential point of sale growth played out in the quarter and any new trends you're seeing there?

There was impressive growth in e-commerce indicating share gains. In point of sale, we continue to gain momentum across all sectors. With people spending more time at home, there is a focus on upgrading and improving spaces. This includes strong trends in DIY and demand for single-family homes, leading to strong performance in residential electronics. Our ability to meet demand has been significant, and I believe our supply chain has demonstrated our capacity to fulfill demand effectively.

That's great. I appreciate that. What about the supply chain for the electronics segment? Are there any risks that could limit growth in the near term?

Aside from the one supplier, we haven't faced disruptions. Demand remains, and our local production capabilities keep us ahead of challenges, benefiting from a simplified and lean supply chain approach. We've been strategic in our efforts that have been paying dividends.

Thank you for the morning, guys. Can you break out EMEA and Asia Pacific just a little bit in terms of geographic performance?

EMEA had a very good quarter. Our SimonsVoss franchise strengthened, put us in position from the pandemic, and enabled the capture of projects. Our Interflex business performed well in access software control time and attendance, showing exceptional execution.

And as far as the US NFC technology shift, are you going to use multiple technologies to get these projects up and running? Is NFC your main focus?

NFC remains crucial to our strategy, but we are investing and partnering with technologies like thread. Opening up to various technologies will extend our capabilities and ensure we remain flexible in meeting customers' needs.

Great. Thank you very much.

Be safe.

Thank you. We’d like to thank everyone for participating in today's call. Have a safe day.