Earnings Call Transcript - REZI Q4 2020

Operator, Operator

Ladies and gentlemen, I would like to welcome everyone to the Resideo Technologies Fourth Quarter 2020 Earnings Conference. Today's call is being recorded. It is now my pleasure to introduce Mr. Jason Willey, Senior Director of Investor Relations. Mr. Willey, you may now begin.

Jason Willey, Senior Director of Investor Relations

Good morning, everyone, and thank you for joining us for Resideo's Fourth Quarter and Full Year 2020 Earnings Conference 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 at investors.resideo.com. We would like to remind you that this morning'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 forward-looking statements. Additionally, during our call today, we may refer to certain non-GAAP financial information. A reconciliation of our GAAP to non-GAAP results is included in the company's earnings press release and accompanying presentation, both of which can be found on the Investor Relations section of our website. We identified the principal risks and uncertainties that affect our performance in our annual report on Form 10-K and other SEC filings. I would also like to remind everyone that we will host a virtual Investor Day on the morning of Thursday, March 11. Information regarding this event is available on our Investor Relations website. With that, I will now turn the call over to Jay.

Jay Geldmacher, CEO

Thank you, Jason, and good morning, everyone. We closed 2020 with a strong Q4, delivering better-than-expected revenue and profitability and making significant progress on our transformation efforts. Demand in our residential markets remains robust, and the ADI team again delivered impressive growth in the face of mixed market conditions in our commercial categories. Our strong finish to 2020 enabled us to achieve modest revenue growth for the full year, despite the unprecedented COVID-19-related challenges we and the global economy faced during the year. While we remain in the early stages of our transformation efforts, initial progress contributed to the margin expansion we delivered in the second half of 2020. This profitability improvement, combined with an increased focus on cash management, generated operating cash flow of $244 million in 2020, up from $23 million in 2019. Improving cash generation is one element of the significant progress we have made in solidifying our balance sheet and enhancing our financial flexibility. In late 2020, we completed a follow-on equity offering, raising $279 million. And after our debt refinancing in early February, we have no significant maturities before 2026. We are well positioned to make long-term value-enhancing investments in both our businesses and augment these organic initiatives with inorganic opportunities. Following a challenging first half of the year, we saw a meaningful improvement in end market demand beginning in the early summer. In the second half of 2020 we delivered strong year-over-year top line growth in both segments and significant margin expansion at Products & Solutions. Investments in our operations and strong execution from our supply chain organization positioned us to deliver for customers as demand accelerated. As we enter 2021, we see a number of positive structural trends across the markets we serve. People continue to spend more time in their homes and are directing their attention and invest to renovation and repair projects. Security has risen in prominence in the minds of many home and business owners. Trends in residential new construction also remain favorable. Our broad portfolio of product solutions, unmatched relationships with the pro channel and distribution reach across home and commercial security markets positions us to capitalize on these positive market dynamics, which we believe have durability. Since I joined Resideo in May, I have focused on accelerating our transformation efforts in building a world-class leadership team. Within Products & Solutions, we reorganized the breakdown silos that existed in the old line of business and engineering structure. We have brought the customer back front and center and are ensuring feedback happens across product management, marketing and engineering. We have reprioritized customer service, with that organization now reporting directly into Phil Theodore, President of Products & Solutions. We have taken several steps towards reinvigorating innovation and technology development across the organization, beginning with bringing Jeff Frank on board. This continues with the recent alignment of resources to create a software and engineering organization, optimized to deliver services through a common platform. Across the board, these efforts position the organization to move quicker to address customer needs and accelerate new product and market development. While many actions are only a few months old, I'm encouraged by the early results. The new ways the organization is interacting and the exciting opportunities that have already arisen. Combined with steps that were taken throughout 2020 to reduce our cost base and refocus resources, we are well positioned to pursue growth while focusing on scalable, efficient business processes. With that, I will turn the call over to Tony to discuss our fourth quarter and 2020 financial performance in more detail.

Tony Trunzo, CFO

Thank you, Jay, and good morning, everybody. Both ADI and Products & Solutions exceeded our expectations in Q4. Consolidated revenue was $1.5 billion, an increase of 15% compared to Q4 last year. For the full year 2020, revenue was up 2% as the strong second half offset the negative impact of COVID-19 in the first half of the year. Q4 gross margin of 28.2% was up 420 basis points from Q4 of 2019 due to improved cost absorption, lower inventory expenses and cost savings from transformation programs. Selling, general and administrative expenses for the fourth quarter totaled $271 million, up 12% from Q4 last year. Included in Q4 SG&A was a $29 million increase in bonus expense from improved business performance and a one-time COVID-related bonus, as well as increased expenses related to transformation programs and investments in the business. Operating profit for the fourth quarter was $152 million, or 10.1% of sales, compared to $72 million, or 5.5% of sales last year. For all of 2020, operating profit was $311 million, or 6.1% of sales, up from $258 million, or 5.2% of sales for 2019. We delivered over $50 million of net savings from transformation initiatives in 2020 compared to our target of $30 million to $40 million. Major factors behind these savings include lower SG&A through headcount reductions and savings on indirect spending, as well as sales activation and direct procurement programs that positively impacted revenue and COGS. In 2021 and beyond, we will continue to focus on reducing costs while increasing scalability, efficiency and control in the business. This work will be visible through our progress on expanding gross margin, leveraging our cost base to improve operating margin and driving cash generation. Products & Solutions Q4 revenue of $676 million was up 18% due to improved demand across each of our major channels: OEM, trade, security dealers and retail. Backlog, while lower than at the beginning of Q4, remains above historic levels. This reflects both positive demand and global sourcing constraints that are impacting our manufacturing operations and supply chain. Products & Solutions operating profit in Q4 was $166 million, or 24.6% of sales, compared with $84 million or 14.6% of sales in Q4 2019. Improved performance reflects operating leverage from higher volume as well as reduced inventory expenses and transformation program savings. ADI revenue of $825 million increased 13% year-over-year in the fourth quarter compared with a strong Q4 2019. Daily sales average for the fourth quarter was $12.5 million, up 10% compared with $11.4 million in Q4 2019. Demand was strong in residential-oriented categories, including intrusion and networking, while more commercial-centric categories, such as fire and access control saw slower activity. ADI's investments in e-commerce and digital selling tools helped drive e-commerce revenue sales over $100 million in Q4, up nearly 40% year-over-year. ADI will continue to invest in digital sales tools designed to drive sales force effectiveness and enable better customer service in 2021. Over time, these investments will enable a more consultative selling approach and a focus on higher-value transactions. ADI operating profit was $59 million or 7.2% of sales, up 13% from Q4 2019. ADI operating profit benefited from higher revenue and a continued focus on cost management, partially offset by increased investment activity as well as restructuring costs in Europe. Corporate costs for the quarter were $73 million or 4.9% of sales compared with $64 million, also 4.9% of sales in the fourth quarter of 2019. For the full year 2020, corporate costs were $291 million or 5.7% of sales compared with $279 million or 5.6% of sales for 2019. The growth for the full year reflects costs associated with transformation initiatives as well as increased bonus and pension expenses, partially offset by transformation program savings and lower spin-related costs. Consolidated cash from operations for the full year 2020 was $244 million compared to $23 million in 2019. This strong performance reflects our improved operating results and lower cash tax payments. As Jay mentioned, we completed a follow-on common equity offering in Q4 that raised $279 million, expanded our research coverage and added several significant new shareholders to our register. As a result of the offering and our strong cash generation, we ended Q4 with cash and cash equivalents of $517 million and total outstanding debt of $1.2 billion. In early February, we refinanced our senior secured credit facilities, consolidating 2 term loans into a single upsized $950 million Term Loan B due in 2028 and extended and increased our revolving credit facility. Separately, we redeemed $140 million of our senior unsecured notes. In connection with the refinancing, Moody's upgraded Resideo's corporate credit rating to Ba3, while Standard & Poor's affirmed its existing issuer rating of BB and changed the credit outlook from negative to stable. These transactions, combined with our strong cash flow, have dramatically improved Resideo's financial structure, reduced net leverage and positioned us for strategic growth initiatives. Moving to our full year outlook. We currently expect 2021 revenue to be in the range of $5.2 billion to $5.4 billion, which implies year-over-year growth in the range of 3% to 6%. Consolidated gross margin is expected to be in the range of 26% to 28% while GAAP operating profit is expected to be in the range of $450 million to $500 million. Our 2021 outlook anticipates corporate expenses of approximately $225 million, capital expenditures of approximately $90 million, effective tax rate in the mid-20s and net interest expense of approximately $47 million. Note that ADI will have 2 fewer selling days in 2021 compared to 2020, reflecting 3 more days in the first quarter and 5 fewer days in the fourth quarter. As a reminder, our Honeywell reimbursement payments have limited tax deductibility, meaning the calculated tax rate on our pretax income will likely be higher than our effective tax rate. For the first quarter of 2021, we expect revenue in the range of $1.3 billion to $1.35 billion, an increase of 12% at the midpoint compared to Q1 2020. Consolidated gross margin is expected to be in the range of 25% to 27%, an increase at the midpoint of 190 basis points. GAAP operating profit is expected to be in the range of $110 million to $120 million compared to $34 million last Q1. Additionally, in Q1, we expect approximately $26 million of costs related to the early extinguishment of debt, which will be reflected on the other expense line of our P&L. Our outlook for both 2021 and Q1 takes into account supply chain constraints associated with COVID-19, higher freight, material expediting charges and market shortages of certain components such as microprocessors. We are working aggressively to mitigate these impacts, and are pleased with how our supply chain and operations teams have responded to the situation. Also included in our outlook for 2021 are incremental investments across the business. At ADI, these investments include systems to accelerate our e-commerce offerings and sales effectiveness, improved customer experience and drive scalable growth. Within Products & Solutions, we will be investing in incremental engineering and innovation capabilities, customer experience, manufacturing optimization, and processes and systems enhancements aimed at accelerating revenue growth and improving gross margins. As a reminder, moving forward, we will not report adjusted EBITDA and instead will focus on revenue, gross profit, operating profit and operating cash flow. As we've stated previously, we believe these GAAP metrics present a clearer picture of actual results against a known benchmark. I'll now turn the call back to Jay for a few concluding remarks before we take questions.

Jay Geldmacher, CEO

Thanks, Tony. I'm proud of what the organization accomplished in what was a very unprecedented year. The entire Resideo team stepped up to the immense challenges in personal and professional daily life brought about by COVID-19. As a company, we excelled at navigating the numerous impacts of the global pandemic while embracing a significant amount of organizational change. I would like to thank all our employees for their efforts in ensuring that we continue to meet and exceed the needs of our customers across the globe. We entered 2021 in a much stronger position than where we were 12 months ago, both as an organization and the demand we see across our markets. We will continue to push aggressively on transformation, including accelerating investments that will position the business for improved long-term growth and profitability. This includes e-commerce expansion and tools to drive improved sales force effectiveness at ADI. Investment in the tools, processes and organizational structure to better measure and improve our NPI and sales execution within Products & Solutions, and better aligning ADI and product solutions to expand opportunities between the 2 businesses. Our focus as a management team remains on rightsizing our cost structure, improving our operational processes and execution and accelerating our innovation and product introduction process. We believe execution across these initiatives will drive improved financial performance and long-term value creation. Finally, I'd like to remind everyone that we will host a virtual investor event on Thursday, March 11, beginning at 10:00 a.m. Eastern Time. We plan to further discuss the opportunities that exist within Products & Solutions and ADI, and outline the longer-term financial framework we see for Resideo. We hope you will join us for this event. This concludes our prepared remarks. Operator, we are now ready for questions.

Operator, Operator

Our first question comes from John Lovallo from Bank of America.

John Lovallo, Analyst

The first one, Tony, just looking at the revenue outlook for the first quarter and then for the full year. It would seem to imply that the back half of the year could actually be down on a year-over-year basis. Is that consistent with what you're thinking?

Tony Trunzo, CFO

The guidance we provided today is for 2021, and for the first quarter, we are not in a position to offer quarterly or semi-annual guidance. However, it's clear that the second half of 2021 will be tougher compared to the very strong second half of 2020. Additionally, we have mentioned that we are facing some supply chain constraints in the early part of the year, which will impact the pacing of our year.

John Lovallo, Analyst

Okay. That's helpful. And then I can certainly appreciate the focus on GAAP results. Just curious, though, will you be breaking out restructuring costs, stock comp, spin-off cost, etc., so investors will be able to, at least, reconcile the numbers to historical results? Or is that something you're just going to back away from completely?

Tony Trunzo, CFO

We will provide details on stock compensation and depreciation and amortization. We will also share specific line items related to EBITDA. However, regarding restructuring expenses and similar items, as previously mentioned, we consider these to be ongoing activities within the business and will discuss them as needed. If they become significant, we might provide a figure, but the expectation is that we will not. Instead, we will incorporate those costs into our operational expenses. This approach is reflected in our guidance, which accounts for these types of expenditures.

John Lovallo, Analyst

Okay. And then lastly, if we think about your guidance, is there any more color you can give us on just a segment basis in terms of revenue and operating profit, I guess, most notably on the trajectory of P&S margin?

Tony Trunzo, CFO

Not at this point. We've obviously seen some meaningful improvement in P&S margins. We expect that to continue. But to this point, we're not in a position to give guidance by segment.

Amit Daryanani, Analyst

I have a couple of questions as well. First, I was wondering if you could discuss your expectations for operating income in 2021. It appears to be a significant increase, roughly $165 million. Could you elaborate on the different factors contributing to this growth? Specifically, will it be driven by volume leverage, transformation savings, or a shift in product mix? What are the primary drivers behind this increase in operating income for 2021?

Tony Trunzo, CFO

Sure, Amit. We are seeing a notable decline in SG&A this year, specifically in GAAP numbers. We mentioned that our corporate expenses are projected to decrease by about $70 million to $65 million next year. We expect to see margin growth in P&S, especially despite the investments we're making in the business. This growth will partly come from increased volumes and also from our transformation initiatives. However, as I noted earlier, we are facing cost challenges in 2021, particularly related to freight, expediting charges, and the costs of acquiring essential components, which are significant. These challenges counterbalance some of the benefits I previously described. Finally, we will continue to invest in the business, as we believe these investments will help drive future growth. We have accounted for these in our plans for 2021 for both P&S and ADI.

Jay Geldmacher, CEO

And I think also, Tony, I think it's worth adding, just on the major transformation initiatives for 2021, really covers a variety of different areas. It's cost, of course, areas of COGS, like value engineering, our European footprint, price optimization activities, or integrated business planning on the SG&A side, SKU rationalization, legal entity rationalization. But also in the area of revenue, we have a profitability management office as part of this new transformation team. And so I think we have a lot of things in flight in the transformation area that will be impactful in 2021.

Amit Daryanani, Analyst

Got it. That's very helpful. Tony, you've mentioned several times the significant inefficiencies and freight costs that affect your margins. Can you quantify what these challenges look like for you on a quarterly basis? How do you plan to counteract this? Will it be influenced by some of the transformation initiatives that Jay discussed, or could this be utilized as a pricing strategy for your customers?

Tony Trunzo, CFO

You want me to take that, Jay?

Jay Geldmacher, CEO

Sure.

Tony Trunzo, CFO

There's a lot that goes into that, Amit. The freight and logistics costs are current. We observed a significant increase in the fourth quarter, and those elevated costs have persisted into the first quarter. We've had to make some estimates regarding how long this situation will last, among other factors. We have done our best to manage this, and yes, they are being offset by all the elements that Jay just described.

Jay Geldmacher, CEO

Yes. I want to add that this is not something new for us. We expect that many companies in the electronics industry will encounter similar dynamics this year. As Tony mentioned earlier, we believe we have taken into account both sides of the equation: the supply chain and logistics challenges as well as developments in the component industries. This transformation and other matters Tony discussed have been considered in our outlook. The situation is dynamic and will evolve over time. Anyone with long-term experience in the electronics industry knows that such fluctuations occur periodically, approximately every decade, and they are influenced by demand in various markets. As Tony indicated, we believe we have covered everything.

Operator, Operator

Our next question comes from Jeff Kessler from Imperial Capital.

Jeff Kessler, Analyst

Jay, you mentioned several times about investments that you made during the year and obviously, are going to be making in e-commerce at ADI. Can you position yourself or where you think the company is right now against your major competitor, let's call, the major 1 or 2 competitors, both here in the United States and abroad with regard to your position in e-commerce and what you have to do to be on the same plane with everyone else?

Tony Trunzo, CFO

Tony here. Regarding our position against competitors, it's hard to determine if we're ahead, behind, or comparable. However, I can say our e-commerce business has experienced significant growth, influenced by industry dynamics. We've already invested a substantial amount and plan to invest even more this year to enhance our e-commerce experience, ensuring customers can easily understand our product offerings and navigate them seamlessly. This focus on digital channels is crucial for us, and we anticipate substantial growth there. Additionally, one of our key goals is to allow our sales associates to concentrate more on sales rather than just transactions, making their interactions more consultative. We do not expect to reduce our investments in branches due to e-commerce. In fact, we plan to sustain and potentially increase branch investments, which we believe will support traditional sales growth as well. Thus, we view the growth in e-commerce as a complementary enhancement as we develop these capabilities.

Jay Geldmacher, CEO

I agree with what Tony mentioned. He is spot on regarding the points he raised. We've been increasing our investment throughout 2020, and we plan to do even more with Rob and his team in 2021. This will involve various initiatives we refer to as touchless sales, including e-commerce, automation, digital marketing, and promotional and sales activation campaigns. I'm very pleased with the progress that ADI has made in this area, and they are continuing to grow significantly. This is a crucial aspect of their future.

Jeff Kessler, Analyst

My follow-up question is that many of your competitors, especially those in the security sector, have been indicating a decrease in revenue expectations for 2021 as the economy slowly reopens. I want to address how you've mentioned, and will likely discuss on March 11, the effort to improve communication and streamline the information flow between ADI and your product team, so you have a clear understanding of what's happening. How do you leverage that as a competitive advantage, particularly as the small to medium business sector, where you operate, begins to recover?

Tony Trunzo, CFO

So Jeff, I’d like to make a few comments regarding that. You highlighted an essential point about the connectivity between P&S and ADI, which we believe is a significant competitive advantage. We are making substantial progress with our new product introduction and innovation efforts, and leveraging a world-class organization like ADI presents a real opportunity. I would like to mention the launch of our Pro series at the end of last year, which has been one of the most successful product introductions, possibly the most successful in ADI's history. You are correct that there is more to explore regarding that connectivity over time, and I believe it will be a crucial factor for us. As for the overall security market, it remains strong. Currently, our top-line constraints are more related to supply chain issues rather than demand, and this holds true for the security sector as well.

Jay Geldmacher, CEO

Yes, I would agree with that. That's all good points, Tony. And I'd also say that there are certain aspects of the commercial market during COVID that was somewhat suppressed because you couldn't get access to on-site. So I think things will begin to change in that dynamic moving forward into 2021, and that should be beneficial.

Operator, Operator

Our next question comes from Paul Coster from JPMorgan.

Paul Chung, Analyst

This is Paul Chung speaking for Coster. I have a follow-up question on e-commerce. What percentage of ADI does that represent? Regarding margins, do you anticipate that benefit will flow through to operating margins? It appears that your gross margins were relatively stable this quarter while your EBITDA margins improved significantly. Was that increase primarily due to cost-saving actions? I'm trying to understand if your e-commerce mix could potentially lead to a long-term improvement in margins overall, and if you can quantify that benefit as this channel grows. I have another question as well.

Tony Trunzo, CFO

Thanks for the question, Paul. E-commerce was approximately $100 million in Q4, which is about 12% of sales, related to ADI. We expect that percentage to grow over time, but not necessarily at the expense of our branches. Rather, e-commerce is expected to be a growth driver in its own right as we enhance our capabilities in that channel, growing faster than ADI overall. We will continue to invest in the business, and while this may create a cyclical discussion, we firmly believe in the ADI business, which has performed exceptionally well for a long time and warrants additional investment. This is why we aren’t seeing significant margin expansion right now—it's due to that investment. We’ll keep investing as long as we see returns, and if those returns lead to accelerated revenue growth compared to our competitors, that itself is a valuable opportunity for further investment. If we were to evaluate the margin profile under steady state conditions, e-commerce should indeed be more profitable due to its lower overhead. However, our perspective is more about seeing it as a sales accelerator and an opportunity for continued market share growth.

Paul Chung, Analyst

Okay. That's actually very helpful. And then on free cash flow, a nice finish to the year. You had a nice benefit from working capital in '20. Are there any kind of initiatives to maybe drive further benefits there? Or is there going to be a slight drag this year on working capital? Just the puts and takes there. And then what do you expect free cash flow to kind of shake out this year? If you could also help us with the seasonality of cash flows to the extent you can, I mean, I guess, '21 was quite volatile.

Tony Trunzo, CFO

Sure. I'll clarify that a bit. Regarding our working capital situation, I believe we've handled it well. Our inventory levels show some tightness in the supply chain, and I don't anticipate seeing improvement in our inventory turnover right now since we are constrained in several areas where we would prefer to have more safety stock, especially with the ongoing strong demand. Looking at collections and accounts receivable, 2020 surprised us positively. We were ready for significant delays and potential issues with our customers' credit quality due to COVID, but that didn't occur. There are opportunities for better execution there, and our days outstanding are relatively good. Additionally, I want to mention a broader perspective: we don't support freeing up cash flow by delaying payments to our suppliers. We did implement that strategy at the start of 2020 during the cautious COVID period, but we've since remained up to date with our vendors and plan to keep it that way. So, considering our other initiatives in 2020, I wouldn't expect a significant improvement in cash velocity or cash cycle time in 2021, as we're concentrating on various other areas and dealing with our inventory issues.

Paul Chung, Analyst

And any comments you can make on kind of seasonality of cash flows? It was quite volatile in 2020?

Tony Trunzo, CFO

Yes. I'm not sure I've looked into that in detail. There shouldn't be significant seasonality associated with it. In January, we always have a number of accruals from the end of the year that we pay in January. Typically, we try to build inventory as we approach our busier season in the third quarter and the early part of the fourth quarter. Overall, it shouldn't be as volatile going forward as it was in 2020.

Operator, Operator

And our next question comes from Christopher Keller from Loomis Sayles.

Christopher Keller, Analyst

I apologize if this was already addressed earlier in the call, I jumped on a little late. Can you make some comments on your ESG, environmental, social and governance initiatives? What you see to be the risks and opportunities there? How you can disclose these items to the market?

Tony Trunzo, CFO

Chris, I appreciate your question, and it's very relevant. We are in the initial stages of our ESG journey, but we are fully committed to it. We believe we hold a strong position in terms of ESG due to the nature of our products and the potential for energy savings and other advantages beyond just the functional aspects. We will share more about this as time goes on. As I mentioned, it's a journey, and I can assure you that our Board and management team are focused on it. This also extends to diversity and inclusion, and we are actively progressing in all these areas within the company today.

Jay Geldmacher, CEO

Yes, I would add also that Tony is 100% right. It's a major focus for myself, the whole management team, and the Board. We just finished up a Board meeting here recently, and this was top of mind. So you'll hear a lot more about this as we move forward during 2021.

Tony Trunzo, CFO

And Chris, thank you for the question. This isn't something that has come up a ton yet with respect to Resideo. But we see it as an opportunity. We see it as a business opportunity. And we also see it as a cultural opportunity to build out what we're about as a company.

Jay Geldmacher, CEO

Yes. It helps define who we are as a company and sets the culture for the various changes we've been implementing over the past year. It's crucial to communicate this not only to our employees but also to our customers and our investors.

Operator, Operator

And that concludes our questions at this time. I will now turn the call back to Mr. Jason Willey for closing remarks.

Jason Willey, Senior Director of Investor Relations

Thank you, everyone, for your participation. And we look forward to speaking with you over the coming weeks. And hopefully, you will join us on March 11 for our virtual Investor Day. Have a good rest of your day. Thank you, everyone.

Operator, Operator

Thank you for joining us today. This concludes our conference. You may now disconnect.