Earnings Call Transcript - REZI Q1 2023

Operator, Operator

Good afternoon. My name is Abby, and I will be your conference operator today. At this time, I would like to welcome everyone to the Resideo First Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you. Mr. Jason Willey, Vice President of Investor Relations, you may begin your conference.

Jason Willey, Vice President of Investor Relations

Good afternoon, everyone, and thank you for joining us for Resideo's first quarter 2023 earnings call. On today's call will be Jay Geldmacher, Resideo's Chief Executive Officer; and Tony Trunzo, our Chief Financial Officer. A copy of our earnings release and related presentation materials are available on the Investor Relations page of our website. We would like to remind you that this afternoon's presentation contains forward-looking statements. Statements other than historical facts made during this call may constitute forward-looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements as a result of a number of factors, including those described from time to time in Resideo's filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements. We identify the principal risks and uncertainties that affect our performance in our annual report on Form 10-K and other SEC filings. With that, I will turn the call over to Jay.

Jay Geldmacher, CEO

Thank you, Jason, and good afternoon, everyone. I'm pleased to say, in the first quarter, we delivered results at the upper end of the outlook we outlined back in February. Over the past several months, we've seen improvements in a number of areas related to supply chain and logistics. Our teams are focused on taking advantage of these improvements to drive gross margin and cash flow improvements as 2023 progresses. While macro signals in our end markets remain mixed, we see opportunities for improved volume trajectory as the year progresses, as customer inventory trends normalize, and we leverage the opportunities we've created over the past 18 months by being a reliable partner to our customers. For first quarter 2023, Products & Solutions delivered revenue of $658 million, up 6% year-over-year, as the addition of First Alert and continued price realization helped offset lower volumes, particularly in our security and energy products. While our Q1 air product revenue was relatively stable year-over-year, we continue to see our HVAC distribution channel manage its inventory levels in the quarter. We expect this channel to continue to manage inventory down as 2023 progresses. In our OEM channel, we believe customer inventory levels have largely normalized and order activity is generally tracking end demand, which has returned to historical trend levels following stronger activity in late 2021 and early 2022. Building on recent momentum, we introduced a number of exciting new products during the quarter that we expect will grow our position in the market. This includes our L1 WiFi Water Leak and Freeze Detector and L5 WiFi Water Shutoff Valve. These First Alert-branded connected devices provide real-time water leak notifications and automatic water shutoff capabilities. The DT4 digital thermostat for EMEA markets, which we introduced in Frankfurt at ISH, the world's leading trade fair for HVAC and water, features a slimmer, modern design, and extensive application support, including heat pumps, hybrids, zoning, and integrates with our underfloor heating solutions. We introduced the HPC-r, an indoor control unit for heat pumps. This is a part of our component portfolio supporting the growing EMEA heat pump market. We also launched the VX1 video doorbell at the ISC West security conference. This product will be available in May and offers AI-based intelligent event detection with video verification. It will also carry the First Alert brand. The first quarter was a productive period of trade show activity, kicking off in January at CES, where we participated in a number of activities focused on home energy management and industry standards, including the Home Connectivity Alliance and Matter. At ISH, in Frankfurt, in March, we showcased several of the new products I have previously highlighted. And at the ISC West security show in Las Vegas, we connected with a large cross-section of our security dealer customers as we launched the VX1 video doorbell. In the first quarter, we saw improvements in our supply chain and the overall logistics environment relative to recent periods. Availability of key electronics and semiconductor components have improved from what we experienced over much of the past 18 months. This enabled us to limit our broker buy activity during Q1, and we currently expect limited broker activity over the remainder of 2023. While we are still carrying higher-than-usual delinquent backlog, levels have shrunk meaningfully from a year ago. With the supply chain beginning to normalize, resources can be shifted from short-term tactical initiatives that have consumed disproportionate engineering time over the past 18 months. This allows our operations and engineering teams to return more of their focus to structural value creation initiatives around new products and value engineering. As discussed on our Q4 earnings call, we have begun our facility optimization work with the announcement of the plan to close our San Diego castings facility, which is expected to be completed in early 2024. This is our first significant manufacturing facility optimization action and ties to a portion of the restructuring charges we took in Q4 2022 and Q1 2023. We expect this activity to begin to positively impact financial performance in Q4 2023. And once completed, the San Diego project is expected to deliver $12 million of annual savings. We've also made significant progress and are ahead of schedule on our El Paso, Texas distribution center consolidation. Most importantly, we have accomplished it with no meaningful customer disruption. This project involves exiting a legacy facility and folding those operations into the El Paso location that came across in the First Alert acquisition. We expect annualized savings of over $2 million per year from this project once fully completed. Overall integration of First Alert is progressing well. We moved the business to our ERP platform in the first quarter and are well on our way to achieving at least our $30 million annualized synergy target. We are expanding the First Alert brand into new product categories. We view the First Alert brand with strong market awareness and reputation as a key asset that we intend to utilize more broadly moving forward. ADI's first quarter reported revenue was essentially flat compared with Q1 2022, with daily average sales up 2%. ADI continues to execute on expanding its ecommerce and digital capabilities, enhancing its exclusive brands offerings and investing in tools to drive sales force efficiency. ADI reached total touchless sales of 39% for the first quarter 2023, and ecommerce revenue was 20% of total sales and grew 17%. ADI saw continued softness in the first quarter in residential AV and security categories and slower growth in several commercial categories. We saw signs of customers managing inventory levels as supply chains normalize across categories, particularly in commercial fire and video surveillance. Over the past several months, the ADI team has actively engaged with suppliers and integrators on the state of the current and expected demand environments. These direct conversations and our integrators survey continue to point to growth in commercial categories in 2023 and a healthy project backlog. With that, I'll turn the call over to Tony to discuss first quarter performance and 2023 outlook in more detail.

Tony Trunzo, CFO

Thank you, Jay, and good afternoon, everyone. First quarter revenue of $1.55 billion was up 3% compared to Q1 last year. Excluding $121 million from acquisitions and approximately $27 million of negative foreign currency exchange impact, revenue was down approximately 3% compared to strong Q1 2022 performance. Operating income was $138 million in Q1 compared to $172 million last year. Fully diluted earnings per share were $0.38 compared with $0.58 in the year-earlier period. Adjusted EBITDA, which includes the impact of the Honeywell reimbursement agreement, was $138 million compared to $173 million in Q1 2022. Products & Solutions' first quarter revenue of $658 million was up 6%. Excluding $98 million from First Alert and approximately $13 million of unfavorable foreign exchange impact, revenue declined approximately 7% compared to last Q1. Price realization remained strong and added approximately $28 million to revenue year-over-year. Offsetting this was a 12% decline in unit volumes, driven by slower residential end demand compared with last year. Security revenue was lower due to continued softness in Europe and lower 3G, LTE, radio sunset migrations in the US. Our US general market security sales also experienced declines during the first quarter. Products & Solutions gross margin in Q1 was 38% compared to 43.3% in the first quarter of 2022. The decline reflects continued year-over-year inflation on labor and certain material inputs, the impacts of reduced volumes on fixed cost absorption, and the inclusion of lower-margin First Alert results. We have begun to see improvements in some materials and freight costs, but these dynamics had a limited year-over-year impact on Q1. Total operating expenses for Products & Solutions were up $18 million year-over-year due to the inclusion of First Alert costs, partially offset by initial benefits of restructuring activities. Products & Solutions operating profit was $117 million, or 17.8% of sales, compared with $154 million or 24.8% of sales last year. ADI delivered Q1 revenue of $891 million, essentially flat to the prior-year period. E-commerce categories, including fire and video surveillance, were up year-over-year, but at slower rates compared to recent periods. Sales in residential security and AV categories contracted in the quarter. ADI gross margin in the first quarter was 19.2% compared with 19.3% last year. We were able to offset the expected waning of inflationary margin benefit with ongoing initiatives around pricing optimization and exclusive brands. ADI operating profit of $72 million was down 10% compared with the prior year. The decline reflects increased investment in strategic areas around digital and systems initiatives. ADI has initiated restructuring activities, including targeted headcount reductions, facilities rationalization, and slower investment spending. We have identified $7 million of cost savings to date and expect to report a $2 million charge in our Q2 results related to these actions. We are continuing to evaluate plans for additional cost reduction at ADI. Corporate costs in Q1 were $51 million, down from $61 million in the prior-year first quarter. Excluding $10 million of one-time First Alert transaction costs in Q1 2022, corporate costs were flat year-over-year. Operating cash flow for the first quarter was a use of $4 million compared with a use of $59 million in the first quarter of 2022. As a reminder, in the first quarter, we made payments on accrued bonuses and customer rebates, which typically makes Q1 our lowest cash flow conversion quarter. Current levels of working capital are being impacted by inflationary impacts in inventory, incremental safety stock, and unfavorable changes to some supplier terms. As the year progresses, we expect to see improvement in working capital metrics, particularly in the Products & Solutions business. Turning to our outlook for the full year. We continue to expect revenue to be in the range of $6.2 billion to $6.55 billion, implying flat revenue at the midpoint. Consolidated gross margin is expected to be in the range of 26.8% to 27.8%, and operating profit is expected to be in the range of $625 million to $675 million, all unchanged from our outlook provided in February. We expect GAAP earnings per share to be in the range of $1.80 to $2.00, which reflects an estimated increase of $24 million, or $0.16 per share, in our Honeywell reimbursement agreement liability to a total of $164 million for the year. Our annual cash payments pursuant to the agreement remain capped at $140 million per year. Adjusted EBITDA is expected to be in the range of $610 million to $660 million for the full year of 2023. Adjusted EBITDA includes the full impact of the $164 million estimated reimbursement agreement expense. For the second quarter, we expect revenue to be in the range of $1.59 billion to $1.64 billion; consolidated gross margin in the range of 26.8% to 27.8%; GAAP operating profit in the range of $150 million to $170 million; and GAAP earnings per share of between $0.41 and $0.51. We expect underlying residential demand to remain soft as we move through 2023. We anticipate improving supply chain dynamics as the year progresses, which should have a positive impact on Products & Solutions gross margin, our working capital metrics and our cash conversion. Improving our cash cycle and overall cash generation is a top priority for the remainder of 2023. We are targeting a 10-day improvement in our cash cycle by the end of 2023 relative to the 69 days at the end of Q1. As a reminder, our full year 2023 revenue outlook assumes mid-single digit volume declines in Products & Solutions, partially offset by carryover price impacts and targeted new price actions. For ADI, our 2023 outlook incorporates low single-digit revenue growth, as modest growth in commercial-focused categories is partially offset by slower activity in residential categories, including AV and intrusion. I will now turn the call back to Jay for a few concluding remarks before we take questions.

Jay Geldmacher, CEO

Thanks, Tony. We remain focused on delivering to our financial targets, improving cash generation, expanding margins and accelerating the momentum on key product and partnership initiatives. Moving into Q2, we expect to see growing benefits from our restructuring activities, and we continue to work on incremental cost-saving opportunities. We are well positioned to improve our margins and overall profitability even in an environment where end market demand remains constrained. I want to thank the Resideo team for their continued focus on delivering for our customers and ensuring the business is positioned for long-term success. This concludes our prepared remarks. Operator, we are now ready for questions.

Operator, Operator

Your first question comes from the line of Erik Woodring from Morgan Stanley. Your line is open.

Erik Woodring, Analyst

Good afternoon, everyone. Thank you for taking my question. I have two questions. First, last quarter you indicated that First Alert was expected to contribute about $120 million in revenue for the March quarter, but the press release shows it contributed around $100 million in total, which is about 20% below the plan. Is that correct? If so, could you help us understand what's going on with the First Alert business? Is there anything noteworthy that we should be aware of? My second question is that you still managed to perform at the high end of your revenue guidance range. Where did you see better-than-expected performance to help offset that? Thank you.

Tony Trunzo, CFO

So Erik, it's Tony. Thanks for the question. There are a few things about the First Alert business. It is somewhat seasonal, with Q1 typically being the weakest quarter. We did experience some softness in retail, particularly at the beginning of the quarter. However, things improved as the quarter progressed, but we still saw a bit of softness. I wouldn't say it was as significant as the $20 million you mentioned; it wasn't that large, but it was noticeable. The other area that was soft was the security business, which we pointed out in our comments. Overall, most other areas performed in line with our expectations and held up quite well. The OEM channel stabilized in terms of channel inventory during the quarter, while the HVAC distribution channel fluctuated, with some strong periods and others where it backed down again. This is somewhat indicative of our current outlook for Q2, as we haven't observed a clear directional change yet. However, the majority of the rest of the business performed as we anticipated or slightly better than we expected.

Erik Woodring, Analyst

Okay. Perfect. That's helpful color. And then maybe just a clarification question on the Honeywell payment. So obviously, it looks like that ticked up a little bit this year. Just why do you owe more to Honeywell this year? And then, can you help us think about the timing of when you expect maybe that incremental payment to come through? And that's it for me. Thank you so much.

Tony Trunzo, CFO

Thanks, Erik. On this call, I'll provide some explanations regarding Honeywell, and we're always available to follow up and provide more details. This is the first quarter we've indicated data below operating income. Historically, we only reported operating income due to the variability in the accounting impact of the Honeywell liability each quarter, as opposed to the consistent $35 million per quarter in cash. That variability typically appeared in other income, below the operating income line. When discussing GAAP EBIT or non-GAAP EBITDA, which includes earnings per share, these factors come into play again. This quarter, the accrual we recognized was $41 million. We've seen this figure reach the $40 million range a few times before. This amount reflects a true-up from Honeywell regarding their five-year estimate for environmental maintenance and remediation costs. They review all properties and overall maintenance costs regularly to provide updates, and various factors like inflation or site-specific changes can influence these costs each quarter. I want to emphasize that this does not affect our cash flow dynamics, either in the short term, where it's $35 million a quarter, or over the life of the agreement, which lasts 25 years—20.5 years remain. Therefore, it does not indicate that we will ultimately pay more to Honeywell in either the short or long term.

Jay Geldmacher, CEO

And I think that's when Tony was discussing it in our remarks, he highlighted that it is capped and we have clarity on that, making it predictable.

Erik Woodring, Analyst

Fair enough. Thank you so much, guys.

Tony Trunzo, CFO

Thanks, Erik.

Jay Geldmacher, CEO

Thanks, Erik.

Operator, Operator

Your next question comes from Brett Kearney from Gabelli Funds. Your line is open.

Brett Kearney, Analyst

Hi, guys. Good evening. Thanks for taking my question.

Tony Trunzo, CFO

Hey, Brett.

Jay Geldmacher, CEO

Hey, Brett.

Brett Kearney, Analyst

With the balance sheet still in good shape and some positive feedback from the commercial contractors and integrators you work with, can you discuss the potential for further ADI bolt-on acquisition opportunities in this environment? Are they still available, and what is your appetite for pursuing more in that area?

Tony Trunzo, CFO

They are still available. As we have discussed previously, the ADI team has a pipeline and is in regular communication with a few potential targets at any given time. We have done a great job being disciplined regarding price and timing. We will continue to pursue those types of deals as opportunities arise. However, the increase in the cost of capital suggests that valuations may have adjusted downwards. Often, during consolidation efforts, sellers need to adapt to a new valuation reality. We might be experiencing some of that regarding timing. Nonetheless, we continue to evaluate these opportunities, and if they make financial sense upfront, they typically align well with our consolidation strategy for ADI.

Jay Geldmacher, CEO

I believe Tony's comment is accurate, and I'd like to add that the current market dynamics have created a greater sense of reality regarding valuations. This allows us to examine these valuations more closely and decide if taking action now is better than waiting. The ADI team has done an excellent job in selecting their acquisitions, and they are satisfied with their progress.

Brett Kearney, Analyst

Great, very helpful. Thanks so much, guys.

Tony Trunzo, CFO

Thanks, Brett.

Operator, Operator

Your next question comes from the line of Paul Chung from J.P. Morgan. Your line is open.

Paul Chung, Analyst

Hi. Thanks for taking my questions. So just on free cash flow, after heavy investments in inventory over the past two years to kind of find growth, how should we think about inventory levels as we exit '23 and as the channel continues to get leaner? And then, you also mentioned cash cycle days goal of around 60 days, which may suggest rebounding back to '21 levels in the free cash flow range there. Is that the right way to think about it? And can you expand on what steps you're taking to drive cash cycle days lower? And I have a follow-up.

Tony Trunzo, CFO

Paul, thanks for your question. The short answer is that to reach our target for reducing the cash cycle, most, if not all, of that will have to come from lowering inventory. We are disciplined in how we pay our suppliers, so we are not utilizing the accounts payable lever. Our days sales outstanding are relatively stable, though they have increased a few days recently. The main focus is to reduce inventory in terms of dollars by the end of the year to achieve the desired level. You're correct that this will bring us down to levels close to 2021, but it will not fully reach the lower levels of late 2020 and early 2021. It's important to point out that those levels were likely artificially low as we were emerging from COVID. At that time, our fill rates were below our expectations, our delinquent backlog was greater than we wanted, and we were just starting to face supply chain challenges, leading us to lean out significantly. In the short to intermediate term, I’m not sure we can return to those previous levels. However, I believe it is feasible to reduce the cycle by 10 days between now and the end of the year, and we are highly focused on achieving that.

Jay Geldmacher, CEO

Yes, I would like to emphasize that our organization is heavily focused on this area. As we mentioned previously, including in February, I’m pleased to report that the supply chain situation has improved significantly. While it’s not completely resolved, there is much more predictability now, allowing us to operate differently without having inventory tie-ups. I’m excited about this opportunity, and we wouldn’t have set that target unless we were confident about it. We recognize how essential this is for various reasons, and the team is dedicated to it. You will hear more about our progress.

Paul Chung, Analyst

Yes, that would put your cash in a great place. That would be fantastic. And then, just a follow-up on the lower component costs, you mentioned were kind of minimal in the quarter. How do you think about the coming quarters? Can we see more meaningful improvement throughout the year in terms of realizing that on the margin front? And then, separately...

Jay Geldmacher, CEO

No, that's all. Go ahead, Paul. Sorry.

Paul Chung, Analyst

Yeah. And then, separately can you expand on some of the pricing power you've had? In the tough environment, do you still have those opportunities to raise prices for a certain product line? And that's it for me. Thank you.

Jay Geldmacher, CEO

Thank you, Paul. Yes, we are going to continue to see opportunities and be able to achieve advantageous pricing regarding our input costs, which we haven't seen in nearly two years. We were paying significantly higher prices due to the supply chain situation. So, that's definitely within our reach, and I anticipate further improvement as the year progresses. We’ve also mentioned that freight costs are much lower than they were, thanks to various dynamics over the past two years, which is crucial. Last year, we had to invest a lot in broker buys, like many companies did, but as I've stated, we have been spending much less and will continue that trend throughout the year. There are many opportunities in this area, and I'm not just satisfied; I can assure you my supply chain team is very enthusiastic about these prospects.

Tony Trunzo, CFO

Yes, Paul, a couple of things. The input costs in the first quarter, particularly due to inflation in materials and labor, were significantly higher compared to last year’s first quarter, and that’s what you observed. Our price realization helped to offset a substantial portion of those costs, but it did not contribute to margin. Our outlook for the second half of the year indicates improved margins and profitability, driven by the easing of some of those headwinds and the potential for further gains through value engineering and supplier management, which should assist in reducing costs in the latter half of the year.

Jay Geldmacher, CEO

The only thing I'll add is that supplier lead times have significantly been reduced, which helps us manage our inventory. Internally, we are investing in improving our supply chain capabilities, and our forecast is getting better. This is important, and we are excited about it. We've discussed in recent months, and really over the last two years, how crucial our relationships with customers are. We are closer to our channels than ever before, and this relationship is continuing to improve. That’s why it’s essential to this discussion; we are more in tune with what is happening with our customers and are receiving valuable feedback from them.

Paul Chung, Analyst

Great. Thank you. Very helpful.

Jay Geldmacher, CEO

Thanks, Paul.

Operator, Operator

Your next question comes from the line of Brian Ruttenbur from Imperial Capital. Your line is open.

Brian Ruttenbur, Analyst

Yes, thank you very much. Just a couple of clean-up questions. You stated I think in last quarter that inventory in the channel should level out in the first quarter. And I didn't know if you could maybe comment on that that you're still very confident that the channel has leveled out and that second quarter, we should see at least stability, and then third quarter recovery. Maybe you can give us a little more color on that?

Tony Trunzo, CFO

I would like to highlight a few points. Firstly, the issue we discussed last quarter was the financial impact from the adjustment of HVAC distribution channel inventory, which we expected to reach its lowest point in Q1. We still believe this is true. The dynamics of this channel have fluctuated, with some strong order periods followed by slower ones over the past four months. It has become somewhat customer-specific in terms of inventory levels and market sentiment, making it feel more dynamic than in the past. We have not yet observed a consistent increase in demand growth. That said, we do not anticipate a significant inventory impact from the HVAC distribution channel affecting our outlook for Q2 or the rest of the year. Additionally, the OEM channel, which also faced excess inventory, seems to have aligned to the levels we and our customers expected. As a result, we see a more streamlined flow from our order book to the end customer without any disturbances in that channel.

Jay Geldmacher, CEO

And I would also add, I think we'll continue to level out through Q2. And also, I think I may mention of it, but our delinquent backlog is coming down. It's not quite where we want it to be yet, but it's coming down significantly. And so that helps in taking a look at the picture that's out there. And so all those things, along with what Tony said, I think, hopefully, helps you understand a little further.

Brian Ruttenbur, Analyst

Thank you. I have a follow-up question. Based on my notes, it seems that residential customers make up about a third of your total while commercial customers represent roughly two-thirds. Have you observed any recent changes in this trend? It appears that commercial is still growing rapidly while residential seems to be declining. Could you share more about the composition of your end customers?

Tony Trunzo, CFO

The mix pertains to the ADI distribution business. The commercial segment has performed significantly better than the residential-focused areas. The residential segments, which include residential AV and residential security, experienced a decline in Q1, whereas our commercial business did see growth during that period. Although this growth was slower compared to previous results, it was still an increase. It's important to note that the Products & Solutions business is mainly residential. In this area, new construction accounts for about 20%, while repair and remodel make up around 80%.

Jay Geldmacher, CEO

That's right.

Tony Trunzo, CFO

But it's heavily residential.

Brian Ruttenbur, Analyst

All right. Thank you.

Jay Geldmacher, CEO

Thanks, Brian.

Operator, Operator

There are no further questions at this time. Mr. Jason Willey, I turn the call back over to you.

Jason Willey, Vice President of Investor Relations

Thank you, everyone, for your participation today. And as always, if you have any additional questions or follow-ups, please feel free to reach out. Everyone, have a good rest of your day. Thank you.

Operator, Operator

This concludes today's conference call. You may now disconnect.