Allegion Plc (ALLE) David D. Petratis on Q2 2016 Results - Earnings Call Transcript

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Allegion Plc (NYSE:ALLE)

Q2 2016 Earnings Call

July 28, 2016 8:30 am ET

Executives

Tom Martineau - Director-Investor Relations

David D. Petratis - Chairman, President & Chief Executive Officer

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Analysts

Joe Ritchie - Goldman Sachs & Co.

Andrew Burris Obin - Bank of America Merrill Lynch

Julian Mitchell - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Jeffrey Ted Kessler - Imperial Capital LLC

Richard M. Kwas - Wells Fargo Securities LLC

Jeremie Capron - CLSA Americas LLC

Peter Richard Lennox-King - Sanford C. Bernstein & Co. LLC

Tim R. Wojs - Robert W. Baird & Co., Inc. (Broker)

Jeffrey Todd Sprague - Vertical Research Partners LLC

Robert Barry - Susquehanna Financial Group LLLP

Operator

Good morning and welcome to the Allegion Second Quarter Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded.

I would now like to turn the conference over to Tom Martineau. Please go ahead.

Tom Martineau - Director-Investor Relations

Thank you, Kaye. Good morning, everyone. Welcome and thank you for joining us for the second quarter 2016 Allegion earnings call. With me today is 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 which we will refer to in today's call are available on our website at www.allegion.com. This call will be recorded on our website.

Please go to slide number 2. 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 SEC filings for a description of some of the factors that may cause actual results to vary from anticipated results. The company assumes no obligation to update these forward-looking statements.

Our release and today's commentary include non-GAAP financial measures, which exclude the impact of restructuring and acquisition expenses in current year and prior-year results. We believe these adjustments reflect the underlying performance of the business when discussing operational results and comparing to the prior-year periods. Please refer to the reconciliation in the financial tables of our press release for further details.

Dave and Patrick will discuss our second quarter 2016 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 then reenter the queue. We will do our best to get to everyone given the time allotted.

Please go to slide 3, and I'll turn the call over to Dave.

David D. Petratis - Chairman, President & Chief Executive Officer

Thanks, Tom. Good morning and thank you for joining us today. I'm extremely pleased with the company's second quarter results. We continue to deliver profitable growth that reflects continued execution of our growth pillars as well as the benefits of investments in the business.

Revenues of $584.9 million grew 12.6%, reflecting organic growth of 8.9% as well as the benefit of prior-year acquisitions. The Americas had organic growth of 9.8%, which was driven by strong revenue growth in our non-residential business. This included an anticipated shift in revenue from Q1 to Q2 associated with our ERP implementation at our Indianapolis facility.

If you recall, we ended the first quarter with elevated levels of backlog associated with the implementation. I am pleased to say we made significant progress in the second quarter through improved throughput and reduced the associated backlog. We caught up on shipments, and I expect a normal flow of shipments for the second half of the year.

EMEA organic revenues grew at 3%, and our Asia Pacific business had a very strong organic revenue growth of 12.9%. If we exclude the previously divested system integration business revenues from prior-year amounts, the Asia Pacific business achieved organic growth of 23.6%.

Adjusted operating income of $125.7 million increased 24.2% versus the prior year. Overall, operating margin improved by 200 basis points. This is the second straight quarter in which all Allegion regions delivered organic revenue growth and margin expansion, once again demonstrating our ability to efficiently leverage incremental volume.

Adjusted earnings per share of $0.99 increased more than 39% versus the prior-year period, driven primarily from improved operating performance, acquisitions and a lower effective tax rate. This is our eighth straight quarter with double-digit adjusted earnings per share growth.

As a result, we are improving our full-year guidance of organic revenue growth to a range of 5% to 6% and total revenue growth of 8% to 9%. In addition, we are tightening our full-year adjusted EPS guidance to $3.30 to $3.40 per share.

Please go to slide 4. Shifting a bit from the financials, I'm equally pleased with our safety performance of our business. We believe that excellence in safety is a True North metric of enterprise excellence. And having a workforce committed to safety is crucial for continued operational success and delivering shareholder value.

As you can see from the chart, Allegion has consistently been a leader among our peers and other manufacturing companies for total recordable incident rates. We incorporate safety in our business system and measure ourselves against annual goals.

Year-to-date 2016, we continue to see an improvement of 13% by forecasting on risk and a reduction of injuries at home and at work. Be safe and be healthy is one of Allegion's core values, and providing and maintaining safe work environment is my number one priority.

Patrick will now walk you through the financials and I'll be back to discuss our full-year 2016 guidance.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Thanks, Dave, and good morning, everyone. Thank you for joining the call this morning. Please go to slide number 5. This slide depicts the components of our revenue growth for the second quarter. I'll focus on the Allegion results and then cover the regions in their respective slides.

As indicated, we delivered 8.9% organic growth in the second quarter with contributions from all regions. Each region contributed to price realization as well as volume growth. Foreign currency was a modest headwind in the quarter, while acquisitions contributed approximately $40 million of incremental revenue or 7.7% growth, which more than offset the impact of divestitures.

Please go to slide number 6. Reported net revenues for the quarter were $584.9 million, which is a 12.6% increase versus the prior-year period. I was pleased with the revenue growth driven by volume increases, the benefit of acquisitions and organic contributions from each region.

As Dave mentioned earlier, our revenue growth reflects increased shipments following our Q1 ERP implementation at our Indianapolis facility. We continue to experience solid electronic product growth, which was up in the mid-teens, and we are realizing the benefits of our new product introductions and channel initiatives.

Adjusted operating income of $125.7 million increased 24.2% compared to the prior year. The benefit of strong leverage on incremental volumes helped deliver 200 basis points of margin expansion versus the prior year. All regions delivered improved operating margins and this reflects the fifth straight quarter of year-over-year margin growth.

Of note, volume increases in our North America non-residential business contributed to favorable mix in the quarter. I will discuss this in more detail when reviewing the Americas slide. I'd also note that we improved our industry-leading adjusted EBITDA margin to 24.2%, an improvement of 260 basis points versus the prior year. All regions improved on this metric in the quarter.

Please go to slide number 7. This slide reflects our EPS reconciliation for the second quarter. For the second quarter of 2015, reported EPS was $0.66. Adjusting $0.05 for prior-year restructuring and acquisition-related expenditures, the 2015 adjusted EPS was $0.71. Operational results increased EPS by $0.18, as leverage on incremental volumes, favorable business mix, productivity and price more than offset inflationary impacts.

The unfavorable net productivity in equation reflects the quarterly timing of certain expenditures. And although foreign exchange was the revenue headwind in the quarter, this was offset by our foreign-denominated costs, resulting a slight favorability to EPS when compared to the prior year.

The decrease in the adjusted effective tax rate drove a $0.05 per share reduction versus the prior year. The improvement reflects favorable changes in the mix of income earned in lower rate jurisdictions and the continued execution of the company's tax planning strategies. Acquisitions, net of divestitures, added $0.03 in the quarter.

Next, interest and other income were a net $0.03 increase to EPS. The higher interest expense is related to the issuance of senior notes in the prior year. Favorable other net items primarily reflects the sale of non-strategic marketable securities. This represents the full liquidation of the securities.

Lastly, incremental investments related to ongoing growth opportunities for new production development and channel management, as well as corporate initiatives were a $0.01 reduction. This reflects an adjusted second quarter 2016 EPS of $0.99 per share, an increase of approximately $0.28 or 39.4% versus the prior-year period.

Continuing on, we have a negative $0.01 per share reduction for acquisition and restructuring costs. After giving effect to these one-time items, we arrive at the second quarter 2016 reported EPS of $0.98 per share.

Please go to slide number 8. Second quarter revenues for the Americas region were $436.5 million, up 8.6% for an increase of 9.8% on an organic basis. Growth in our electronics products increased 15% versus the prior year, as we continue to see better-than-market growth from this product category in both residential and non-residential markets.

The non-residential segment delivered double-digit revenue growth in the quarter. Pricing remains solid, and end markets are performing as expected, with growth in both commercial and institutional areas. Additionally, the second quarter results were inclusive of higher-than-normal shipments at our Indianapolis facility, which underwent an ERP implementation in Q1 and had experienced delays in shipments. On a year-to-date basis, the non-residential segment grew high-single digits.

The residential business grew at low-single digits after excluding the divested Venezuela business from prior-year results. Volume growth in new construction builder channels and e-commerce was partially offset by pricing weakness. On a year-to-date basis, the residential segment has grown mid-single digits, consistent with the original market expectations shared during our February call.

Americas adjusted operating income of $130 million was up 16.2% versus the prior-year period. Adjusted operating margin for the quarter increased 200 basis points. The margin improvement was driven by strong volume leverage and favorable mix, attributable to the strength of non-residential growth.

Overall inflation was largely offset by pricing and productivity in the quarter. The higher inflation reflects some quarterly timing differences. When looking at the year-to-date performance, pricing and productivity more than offset inflation. We would expect this to be the case for the balance of the year, although we are expecting to see some additional commodity inflation pressure in the second half.

And as noted in the presentation, investments have been a modest headwind year-to-date. We expect additional investment headwinds to be back-end loaded for the Americas segment.

Please go to slide number 9. Second quarter revenues for the EMEA region were $121.6 million, up 44.9% or up 3% on an organic basis. The organic growth reflected solid price realization and good performance across most geographies. Acquisitions delivered approximately $35 million in incremental revenue.

We have not seen any meaningful impact from the UK EU referendum vote or Brexit. It's too early to quantify any potential impacts for business or industry, but I would note that the UK sales are historically less than 10% of our EMEA portfolio.

EMEA adjusted operating income of $9.3 million increased 116.3% versus the prior-year period. Adjusted operating margin for the quarter increased 250 basis points and adjusted EBITDA margins increased 440 basis points, reflecting continued improvements in the ongoing business transformation as well as contributions from the recent acquisitions, which were accretive to the region's margins. This represents the sixth consecutive quarter with year-over-year margin improvement.

Please go to slide number 10. Second quarter revenues for the Asia-Pacific region were $26.8 million, down 20% versus the prior-year period. As noted on the slide, the decrease was specific to the divestiture of the system integration business, which drove a $15.2 million reduction in revenues year-over-year.

Excluding the system integration business and prior-year numbers, total revenue grew 46.2% and organic revenues grew approximately 23.6%. Most sub-regions performed well, with notable strength in China hardware and Australia and New Zealand. Asia-Pacific adjusted operating income was $2.3 million, which reflects an improvement of $3.7 million versus the prior-year period.

Adjusted operating margin for the quarter increased 1,280 basis points versus the prior-year period. Operating margins improved 830 basis points, excluding the previously divested system integration business and acquisitions. The increase in margin reflects strong volume leverage, cost improvements and year-over-year benefit of divesting the system integration business as well as the acquisitions.

Please go to slide number 11. Year-to-date available cash flow for the second quarter 2016 was $84.7 million, a $69.9 million increase versus the prior year. The improvement in available cash flow is primarily attributable to increased earnings, decreased operating cash requirements and lower capital expenditures.

As evident in the increased ratios on this slide, we now reflect the impact of recent acquisitions and divestitures in the current numbers. We remain committed to an effective and efficient use of working capital. And lastly, we continue to guide full-year available cash flow of $280 million to $300 million, an increase of 26% to 35% compared to the prior year.

Please go to slide number 12. You will remember our capital allocation strategy that defines a balanced and flexible approach. The company improved its debt to EBITDA ratio to 3 times at the end of the second quarter, in the middle of our targeted long-term range of 2.75 times to 3.25 times. This represents a 0.5 turn improvement over the ratio at 12/31/15 of 3.5 times. The decrease in the leverage ratio is a component of increased EBITDA and normal debt amortization, and demonstrates the ability of our company to de-leverage quickly from profitable growth, low capital requirements and strong cash generation.

Additionally, I wanted to highlight that Standard & Poor's upgraded Allegion to investment grade during the second quarter of 2016. We continue to see opportunity to fund incremental investments in organic growth for new product development, channel strategies and enterprise excellence to accelerate core market expansion. Supported by our 2016 performance, we continue to believe these investments will enable the company to grow at an accelerated pace and faster than the broader market with high returns on invested capital.

We remain focused on growing our portfolio through acquisitions. During the second quarter, we completed the acquisition of Trelock GmbH. Trelock, a portable safety and security provider producing bicycle locks, lights and electronic control units, strengthens our global portfolio, security and safety offerings.

We will continue to evaluate acquisitions that are core to our business and can expand our global footprint and product portfolio and provide a favorable return on invested capital. And lastly, we have the opportunity to provide shareholder distributions through increased dividends and share repurchases.

In summary, due to consistent high cash flow generation, we have many options to deploy capital to drive value for our shareholders.

I will now hand the call back over to Dave for an update on our full-year 2016 guidance.

David D. Petratis - Chairman, President & Chief Executive Officer

Thank you, Patrick. Please go to slide 13. We are improving our 2016 guidance for revenue and EPS, as noted on the slide. We are increasing revenue growth for all regions, given first half performance and our expectations for the remainder of the year. This results in total organic revenue improving a full point versus prior guidance to a range of 5% to 6% and total revenue improving to a range of 8% to 9%.

If we look closer at the Americas business, residential market indicators still suggest continued growth. New construction starts are approaching 1.2 million, with resilient strength in the multi-family segment. The residential aftermarket is also performing well, given increased home pricing and low mortgage rates. Non-residential markets continue to perform well and we continue to expect slow and steady improvement in our core non-residential segment.

Within major institutional verticals, we still expect modest growth in education and are seeing slight improvement in healthcare aftermarket with an increase in renovation and additions. In the commercial segment, office construction remained strong, driven by employment growth and reduced vacancy rates.

The European markets have stabilized and we continue to see modest growth in our core geographies, which is reflected in the increase of our organic guidance. We are still recognizing the benefits of prior-year acquisitions and are leveraging a broader portfolio to accelerate growth.

In the Asia-Pacific segment, we continue to make progress with a focus on mechanical and electrical hardware solutions in growth verticals; for example, multi-family in Australia and New Zealand and transportation in China.

We are also tightening and raising the low end of EPS guidance, reflecting confidence in achieving the improved top-line outlook. However, we are anticipating some pressure on second half earnings due to the inflationary headwinds, second half weighted investments and a tax rate at the high end of prior guidance. I would also note that our guidance now reflects the inclusion of the Trelock acquisition for the second half of the year.

Please go to slide 14. Let me finish by reiterating that I'm very pleased with our second quarter execution and results. As a summary, total revenue grew over 12%, organic revenue grew almost 9%, operating margin increased 200 basis points. EBITDA margins grew 260 basis points. EPS grew over 39%. These are strong numbers. We have increased our revenue growth expectations for the year and have tightened the range for our full-year EPS outlook.

Before we take questions, I'd like to take a moment to share some news with regard to an organizational change at Allegion. Tom Martineau will be assuming the role of Vice President of Finance for the EMEA region. As you know, Tom has been in the Investor Relations role since the creation of Allegion. During this time, Tom has established the company's investor relations program and has served as a valuable voice of the shareholder community along with the leadership team. This is a great opportunity for Tom and I'm sure you all want to congratulate him on this exciting move.

As we move forward, Mike Wagnes, Allegion's Vice President and Treasurer, will assume the additional responsibilities of Investor Relations. Mike has been with Allegion and Ingersoll Rand for 10 years and brings a wealth of financial experience that will position him well as the company's primary representative to the investment community.

Congratulations to you both. The transition will occur over the month of August with formal transition by the end of August. Please continue to contact Tom during this time for any investor-related questions.

Now, Patrick and I will be happy to take your questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. The first question comes from Joe Ritchie of Goldman Sachs. Please go ahead.

Joe Ritchie - Goldman Sachs & Co.

Hi. Good morning, everyone. And congratulations to both Tom and Mike.

David D. Petratis - Chairman, President & Chief Executive Officer

Well deserved. Thank you.

Joe Ritchie - Goldman Sachs & Co.

My first question maybe, Dave, just touching on your comments on the inflationary headwinds heading into the second half of the year. It looks like you've got a little bit of a lower pricing benefit this quarter than you did in 1Q. And you have your competitor in Europe that has been talking about putting through pricing increases because of these inflationary pressures, even starting as early as next quarter. And so, maybe just talk about your ability to pass on additional pricing increases as we head into the second half of the year?

David D. Petratis - Chairman, President & Chief Executive Officer

So we see inflation on the rise. We think the market remains disciplined and we'll pass the higher costs through. Extremely pleased with the global supply chain's procurement organization that we created here at Allegion. It's driving some productivity in the first half and I think that's how you need to think about the inflation, price productivity take-off as you think about our 2016 results.

Patrick has got some comments.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah, Joe. So, a couple of quick things. As you saw in the results, Q2 sequentially down a little bit and pricing up, still a pretty good traction in non-resi. The pressure there was more on the residential side. Nothing really out of the normal course of business, but some added costs associated with rebates, advertising, merchandising, credits, those type of things.

We would anticipate the back half to improve relative to Q2. So, as Dave mentioned, still anticipate to kind of pass on to the extent we can pricing relative to the increase and inflation. But there is always a lag attached to that. And as it relates to inflation, as you know, I mean the commodity input costs are rising, particularly steel which is up, the last numbers I saw, like 60% relative to the beginning of the year in terms of spot rates. So, that's going to put a little pressure on our numbers in the back half of the year.

Joe Ritchie - Goldman Sachs & Co.

Okay. That's fair. And maybe one quick follow-up, Patrick. Just on the EMEA margins, still you are continuing to progress there. I think you guys had a double-digit expectation for the year. So I'm just curious whether that's changed at all and just maybe provide a little bit of color around that.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So we're still marching forward to the double-digit expectations in terms of margin performance. I'd say there's a little bit more pressure there in terms of what we originally anticipated, given some of the inflationary headwinds we talked about. We've stepped up some of our investments in the business as well to better position us for growth going forward, particularly as we look at our long-range planning cycle in 2017 and beyond. So, that's going to have a little pressure as well.

But if you look at the business in the quarter, good performance; EBIT margins up 250 basis points; EBITDA, 440 basis points. So we like the progress there. We're executing to our margin improvement plan. But maybe a little bit of delay, but collectively a good story. Particularly when you look at where we started the journey, you may recall 2013 was like a 1% EBIT margin.

So, significant progress, continue to move forward, probably not as quick as we would like, but yet we're not capitulating on our 10% objective.

David D. Petratis - Chairman, President & Chief Executive Officer

Joe, I would add to that, fully committed for double-digit profitability in Europe. I think the execution by the team there and the amount of restructuring that has gone on since we created Allegion is noteworthy. And overall, we're confident that we can deliver that.

Joe Ritchie - Goldman Sachs & Co.

Great. Thank you.

Operator

The next question comes from Andrew Obin of Bank of America. Please go ahead.

Andrew Burris Obin - Bank of America Merrill Lynch

Yes. Good morning, guys.

David D. Petratis - Chairman, President & Chief Executive Officer

Hi, Andrew.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Hey, Andrew.

Andrew Burris Obin - Bank of America Merrill Lynch

And congratulations to Tom and Mike.

Tom Martineau - Director-Investor Relations

Thanks, Andrew.

Andrew Burris Obin - Bank of America Merrill Lynch

Just a question on your EPS guidance for the second half. As I look, we have positive top-line growth in the second half. But, basically, your EPS guidance implies no EPS growth or EPS decline in the second half. And I'm just wondering if that's how the math has worked out and we're being conservative or we really do think that there is $30 million, $40 million of incremental cost that's you're going to true-up in the operating improvements in the second of the year.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So I think you've got to look at it and break down the P&L in a couple of segments. We do, as we say, anticipate continued growth both organically as well as including the acquisitions. The continued growth in EBIT/EBITDA margin performance, and that's across all regions in the back half of the year, a little bit increased as it relates to corporate expenditures.

But then when you go below the line, it's when the year-over-year comparabilities get very difficult. So you've got – you may recall, last year, other income was up on the sale of marketable securities. We had a lower tax rate last year because of some favorabilities from one-time items there that are non-recurring this year.

And so it's the below-the-line items that are putting the comparisons difficult in the back half of the year. But continued growth, as you would anticipate, in each of the regions for the balance of the year.

Andrew Burris Obin - Bank of America Merrill Lynch

But let me just rephrase the question. Operating leverage in the quarter was in the high-30%s. Do you see a material step down in operating leverage in the second half of the year because of the investments? Because you're describing investments and cost pressures as marginal, but should we see a material decline to the point where we're not going to see any operating leverage in the second half?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

So there's going to be operating leverage, not to the extent you saw in Q2, and for the reasons that you mentioned, higher back-end loaded investments. When we initially gave our guidance back at the beginning of the year, we're anticipating $0.10 to $0.15 of investment headwinds. We're a little bit north of that guidance now. Inflationary headwinds is also affecting the numbers a little bit. So, collectively, those items – or sequentially, you won't see the margin leverage that you saw in Q2.

David D. Petratis - Chairman, President & Chief Executive Officer

I would also add, Andrew. We do have a system here at Allegion that helps us to anticipate the future with confidence. I also want the optionality in investments in our business to invest for the long term, and I think this is important as how we guide the company.

I think we've been good stewards of that investment, and I don't want to put myself in a position where we can't make the investments in demand creation activities, the pursuit of electronics which we think are good for shareholders over the long haul.

Andrew Burris Obin - Bank of America Merrill Lynch

And just a follow-up question. On discretionary retrofit market in the U.S., I know you are working to increase your market share there. Any update on the progress as to what you've seen in the quarter and what impact that has had on organic growth in North America in Q2? Thank you.

David D. Petratis - Chairman, President & Chief Executive Officer

We continue to be pleased with our execution in the renovation and retrofit segments of the market. We continue to learn and invest, and it had an impact on the quarter. With that, as we learn and expand there, we're creating new segments to go after within the channel. So it's an example where we're seeing good growth, but we're also investing in more people capacity to segment the markets and drive growth in the business.

Andrew Burris Obin - Bank of America Merrill Lynch

Terrific. Thank you.

Operator

The next question comes from Julian Mitchell of Credit Suisse. Please go ahead.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Thanks. Good morning, and thanks, Tom, for all the help. So my first question would be around the residential business in the Americas. As you said, organic sales growth slowed down a little bit year-on-year in the second quarter versus the first quarter. Was that all pricing or did you see something change in volume as well? And then maybe just give some context around the competitive environment in residential Americas, please.

David D. Petratis - Chairman, President & Chief Executive Officer

I would say look at our growth on a full-year basis. We're mid-single digits there, about what we anticipated. I think if you look at the broader community of competitors, there is a price pressure on the opening price point. As I look at our business in the first half, we grew and improved profitability, and don't really want to get sucked into the opening price points of the market. And there is growth there. We just have chosen to play at a higher level.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Very clear. Thanks. And then a quick follow-up just on the Asia business. And obviously, a lot of change in the portfolio there, an acquisition and a big divestment in the past 12 months. How should we be thinking about the pace of improvement in this business in margins over the next couple of years, let's say?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So we had targeted this year kind of mid-single digits. You saw really good performance in the second quarter, a little bit north of that expectation. The business is somewhat seasonal, so you kind of see, particularly in Q4, stronger margins expectations than Q2.

Going forward, as the business grows, it will continue to show some leverage. And we're targeting in the near-term horizon have a 10% margin opportunity is where we'd like to see the business go with kind of high-single digits to low-double-digit growth in that business.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Very helpful.

David D. Petratis - Chairman, President & Chief Executive Officer

I would add some to that. I think, if you look at our journey in Asia-Pacific, there's been a tremendous transformation in that business. They're focused. They've got the core capabilities of our European product portfolio, our North American product portfolio and are, I think, attacking segments that are helping us drive growth. There's been some smart capital allocation in acquisitions. And I think we've got a bright future as a small player in Asia-Pacific that will benefit us over the long haul.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Thank you.

Operator

The next question is from Jeff Kessler of Imperial Capital. Please go ahead.

Jeffrey Ted Kessler - Imperial Capital LLC

Thank you. And again, congratulations to Tom and to Mike. Tom, it's been great working with you. Hopefully we can keep talking from time-to-time.

Tom Martineau - Director-Investor Relations

Thanks, Jeff.

Jeffrey Ted Kessler - Imperial Capital LLC

When you take a look at the other segments of the security industry that have been reporting and that have been reporting in mass in terms of what the industry segments are doing, when you look at things like video, when you look at things like overall security integration, those areas have been growing at a little bit of a slower rate than what we're seeing in your area, which is counter to what lots of people have been thinking about, video being the fast grower. Yes, units have been growing, but obviously there's been more price degradation than we've seen on your side because of manufacturing in the Far East.

What I'm getting to is what is the reason – what do you see as a value proposition for driving the growth rate that you guys have in your part of the business at or above other parts of the industry level?

David D. Petratis - Chairman, President & Chief Executive Officer

I think it goes back to the mote that we describe around this business and that's the mechanical complexity that we deliver at Allegion in a market that's consolidating. I can look at some direct competitors that are not growing at the pace that we are. Allegion has made investments in our core mechanical as well as electronic. And I think it helps differentiate us versus some of the electronics that have lower barriers to entry.

You mentioned that the video market has slowed. Clearly, that market is reaching maturity in some cases. But it's really the number of competitors that are out there. We like our position and we think the growth that we're driving because of the complexity in the investments will reward us.

Jeffrey Ted Kessler - Imperial Capital LLC

Okay. Just as a quick follow-up, can you give some indication of what percentage of your new sales are now coming from what we'll call electro-mechanical or electronic versus just pure mechanical?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So we've grown the overall portfolio in electronic products, as we indicated, up mid-teens for the quarter. That's commensurate kind of with a little bit higher than what we saw in Q1. It continues to be a larger part of our portfolio. It's at kind of the low-teens to mid-teens area as a total percentage of our portfolio.

Jeffrey Ted Kessler - Imperial Capital LLC

Okay. Great.

David D. Petratis - Chairman, President & Chief Executive Officer

I think too the acquisitions also complement. SimonsVoss, a great add, Milre (38:55), our own presence with Schlage, helps us to understand the important of dimensions for customers and technical evolution around firmware, software, miniaturization and battery life that are going to be important in this industry. You integrate that into our mechanical platform, I think it puts us in a nice position.

Jeffrey Ted Kessler - Imperial Capital LLC

All right. Great. Thank you very much.

Operator

The next question comes from Rich Kwas of Wells Fargo Securities. Please go ahead.

Richard M. Kwas - Wells Fargo Securities LLC

Hi. Good morning, everyone. And good luck, Tom. Thanks for all the help too and look forward to working with you, Mike. Just on the European margin, so is the 10% core still intact for this year, Dave?

David D. Petratis - Chairman, President & Chief Executive Officer

I think certainly within – it's achievable. It has some pressure, and it's really on the timing and shifting of tooling to lower cost manufacturing areas. So, it's a risk point, but our modeling would say achievable.

Richard M. Kwas - Wells Fargo Securities LLC

Is that a...

David D. Petratis - Chairman, President & Chief Executive Officer

I want you to have – there's several hundred tools that we're moving, and this is not necessarily a casual activity I would say. So there is some headwinds in the timing, but we believe 10% is achievable.

Patrick, can you get...

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. Rich, I would just say it's not a question of do we get there. It's more of a timing issue. And as Dave indicated, with some of these moves from a production facility perspective, we'll probably delay the realization of that this year, be pushed into 2017. But the objective remains intact in terms of the end game. And again, collectively, looking at the region as a whole, still pretty good performance.

Richard M. Kwas - Wells Fargo Securities LLC

So, would the guide incorporate something less than 10% in the spread – in terms of the EPS spread?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Not looking at the region in total, okay? But if you look at the components within the European region, base business versus acquisitions that are accretive to the margins, yes.

Richard M. Kwas - Wells Fargo Securities LLC

Okay. All right. And then, just longer-term on Europe, so does this mean that getting to where Assa is right now, and I know you haven't given formal guidance longer-term on European margins, but does this push out your original thoughts around that on getting to that level or is this just kind of we catch up, there's a time to catch up, and we still think over the longer-term basis we can get to at high-teens type, mid-high-teens margin rate in Europe at some point?

David D. Petratis - Chairman, President & Chief Executive Officer

I think you need to target mid-teens. Assa, kaba+dorma (42:04) is who we benchmark to. I think it's also dependent on future acquisitions, but we've made ground up quickly and I think that mid-teens aspirations is achievable.

Richard M. Kwas - Wells Fargo Securities LLC

Okay. All right. And last quick one for me on electronic growth. So, mid-teens, there was a step-up from last quarter low-double digits. Is this the right framework in terms of growth rate going forward or is mid-teens really comfortable with that?

David D. Petratis - Chairman, President & Chief Executive Officer

Comfortable.

Richard M. Kwas - Wells Fargo Securities LLC

Okay. Thank you.

Operator

The next question is from Jeremie Capron of CLSA. Please go ahead.

Jeremie Capron - CLSA Americas LLC

Thanks. Good morning and thanks, Tom, for all your help and the best to you.

Tom Martineau - Director-Investor Relations

Thanks, Jeremie.

Jeremie Capron - CLSA Americas LLC

Question on the outlook for the second half and in the Americas in particular. It seems like your guidance embeds a slowdown in the revenue growth rate. In organic growth, you've been running well above 5% for what two years now, with the exception of the first quarter and the production disruptions. But it seems to me that your guidance embeds something below 5%. Is that correct? And what's driving this pricing slowing down, or any – because your commentary on the market sounded pretty optimistic. Thanks.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So I think you've got to look at first half, second half. Q2 was abnormally high, given some of the catch-up relative to the ERP implementation, which we now have behind us. But you kind of look at the first half, mid-single digits. Second half, slightly lower than that. So your comment is correct.

Predominantly because, last year, we had difficult – or we had really strong quarters, particularly in the residential business where we had some load-ins on new products. You may recall the launch of the Schlage Sense product, which was a big driver in Q4 in particular last year. So, that's kind of what we're looking at. Difficult comparisons.

But the core business will continue to grow. Again, we're making really good traction on our initiatives in terms of some of the new product launches. The channel initiatives Dave talked about, the retrofit opportunity, we're getting good traction there. So it's more about more difficult comparisons in the back half of the year.

Jeremie Capron - CLSA Americas LLC

Understood. And going back to the topic of commodities and middle prices going up, can you maybe help us quantify the potential impact and maybe help us understand a breakdown of your bill of materials?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So I won't get into the specifics in terms of bill of materials. But we had commented previously, raw commodity cost of roughly 10% of our material purchases, steel being probably 50% of that. So, that's the biggest commodity input. That's the biggest mover that we've seen recently.

If you try to quantify it, it's probably putting on additional pressure $0.02 to $0.03 in the back half of the year. We managed that through supply lock contracts, but everything is not hedged. And so, the unhedged portion kind of flows through the business as we purchase those components.

Additionally, obviously you've got from our supply base, they're buying the same inputs and so you've got pressure in terms of potential cost increases from our suppliers that also come into the equation. But we'll continue to manage it and offset it. As we said earlier, we have the mechanism to try to do that through pricing.

Jeremie Capron - CLSA Americas LLC

Great. And maybe just last one for me. I noticed the increase in working capital as a percentage of revenue. Should we consider this as transitory?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So we continue to focus on working capital. A couple of things worth noting here. The acquisitions, so the businesses we've acquired, predominantly being European based, have higher working capital needs and that's distorting the year-over-year comparatives. If you kind of back that out, we're at about 5% working capital as a percentage of revenue, about 50 days cash conversion cycle. So there is some of impact of the acquisitions which, hey, look, we'll continue to drive that and look for ways to become more efficient.

Secondly, as it relates to some of these facility moves and the ERP implementation, you carry higher inventory and safety stock. So, as we make those transitions, effectively we'll burn more inventory. And so the numbers should come down. But longer-term basis, I would anticipate us to be able to operate effectively, efficiently at about a 5% working capital as a percentage of revenue.

David D. Petratis - Chairman, President & Chief Executive Officer

I would reinforce about our ability to be as efficient. I would add that Patrick's comments is the peak of the construction season. This business leverage is incredibly, don't want a lack of material or finished inventory to inhibit our ability to drive revenue. And there's clearly a shift in philosophy about that with Allegion. Have our product available at our wholesalers, in our warehouses, and continue to drive our industry-leading lead times, and it helps us to grow.

Jeremie Capron - CLSA Americas LLC

Thank you.

Tom Martineau - Director-Investor Relations

And I would like to comment – Thanks, Jeremie. And this is Tom. I would just ask, let's try to keep the question maybe to one question the rest of the way. We're going to run pretty tight today.

Operator

The next question is from Steven Winoker of Bernstein. Please go ahead.

Peter Richard Lennox-King - Sanford C. Bernstein & Co. LLC

Oh, hi, everybody. This is Peter on for Steve. Could you maybe talk through, put a bit of a finer point on – within the Americas for Q2, how much of the growth was actually from ERP catch-up and therefore sort of one-time in nature? And any dynamics we should be expecting from there?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. You may recall, Americas I think was essentially flat in Q1 and we anticipated kind of mid-single digits last quarter. Q2, we caught up predominantly on the shortfalls related to the ERP implementation and in the ops. So, great progress there. That's why you saw the really high organic growth.

I'm not going to give you a specific number, but just to say, we've gotten all of that kind of behind us. You may recall, we had anticipated it would be a 50%/50% split Q2/Q3. So we're now at a normal run rate I think going forward. But it did impact kind of the organic growth, let's say, maybe 3 to 4 points.

Tom Martineau - Director-Investor Relations

Yeah. And I would say the first quarter was kind of low-single digits was the growth rate.

David D. Petratis - Chairman, President & Chief Executive Officer

Overall, I'd guide you to look at our first half year-over-year. And what I'm pleased with that we're seeing growth in all of our business lines, closers, locks, exit devices, and I think it shows the strength of the market.

Peter Richard Lennox-King - Sanford C. Bernstein & Co. LLC

Okay. That's great. And actually, if I could just sneak in a follow up. I had thought that in Q1 that absent the ERP impact that electronics growth was in the high-teens, and so excluding the ERP, and it was higher before that in 2015. Is that a slowing or is it just sort of steady as she goes and the dynamics are actually pretty consistent?

David D. Petratis - Chairman, President & Chief Executive Officer

I think you need to think about this as mid-teens. Remember, we've had a lot of new product introduction over the last several quarters. Globally, this is forecasted to grow at high-single digits. So I think our mid-teens reflects our execution and how you ought to think about that.

Peter Richard Lennox-King - Sanford C. Bernstein & Co. LLC

Okay. Great. Thanks very much.

Operator

The next question comes from Tim Wojs of Baird. Please go ahead.

Tim R. Wojs - Robert W. Baird & Co., Inc. (Broker)

Hey, guys. Good morning. Hey, Tom, it's been great working with you, and congrats on the role.

Tom Martineau - Director-Investor Relations

Yeah. Thanks, Tim.

Tim R. Wojs - Robert W. Baird & Co., Inc. (Broker)

My question is really just on M&A. And I guess I'm curious how are you feeling about the cadence of M&A this year, and how do we think going forward what your ideal cadence is? And I'm just asking because last year you did maybe five acquisitions and year-to-date you're closer to one. So I'm just curious how the pipeline looks and how you guys could kind of think about the ideal cadence of M&A going forward.

David D. Petratis - Chairman, President & Chief Executive Officer

Obviously, we'd like more. It's a function of availability, timing. We continue to work on the pipeline, the relationship building. And it's the nature of the beast. Sometimes these come in dumps and lumps. But the overall market, the relationship we're building, we feel good about.

What's the level of revenue we'd like to add? I'd like to think $50 million to $200 million on an annualized basis would be a nice cadence. But I want to remind you we're going to be disciplined in the capital deployment and bolt on what's right for Allegion. So, that's how I'd describe it.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. Tim, I would just add. Continue to be selective, make sure it's aligned with our core business and strategies, things that we can leverage well to get a good return on capital. And hey, we're just as busy as we were last year. We're looking at a lot of potential properties at various stages, and it just depends. We're not going to overpay for anything. We're going to stick to our knitting and buy some good businesses.

Tim R. Wojs - Robert W. Baird & Co., Inc. (Broker)

Great. That's helpful color. I appreciate it. Nice work, guys.

David D. Petratis - Chairman, President & Chief Executive Officer

Thank you.

Operator

The next question comes from Jeffrey Sprague of Vertical Research Partners. Please go ahead.

Jeffrey Todd Sprague - Vertical Research Partners LLC

Thank you. Good morning, everyone. Congrats to Tom. Maybe, condolences to Mike. It sounds like he's getting two jobs for the price of one, but look forward to working with you.

David D. Petratis - Chairman, President & Chief Executive Officer

No good deed goes unpunished for both of these guys.

Jeffrey Todd Sprague - Vertical Research Partners LLC

Exactly. I'll keep it to one question. I know we're up against the wall here. Just on the balance sheet, I don't think you were ever actively seeking an upgrade to investment grade. I just wonder if that now, though, colors your thinking on the balance sheet at all. Or in your discussions in achieving that upgrade, are the rating agencies comfortable with you at least flexing up to that 3.25 times? Maybe they're even comfortable with you flexing higher than that with visibility to bring it down.

Just give us some perspective on your thoughts around that and if there is any change in thinking at all about the balance sheet?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

No changes at least in the near term. We've been very transparent with our financial policies with the rating agencies from day one, and nothing has changed from that, as you're aware, relative to our capital allocation strategy. So the upgrade came on basis of the strength in our franchise and prospects going forward, strong cash generation, good growth prospects, EBITDA consistency, margin profile. All those type of things I think factored in the upgrade. And I think it's a benefit for us kind of going forward and looking at financings, and hopefully, we can take advantage of.

But no changes relative to our long-term debt to EBITDA, which we kind of had targeted 2.75 times and 3.25 times. And, hey, if we find a good opportunity, transaction in the horizon, it doesn't mean we can't go north of that. And we've communicated that with the rating agencies as well. They understand that. The beautiful thing about our business is we do de-lever very quickly, given the strong margin profile and the cash generation. So they're all aware of that and it came on the heels of that information.

Jeffrey Todd Sprague - Vertical Research Partners LLC

Understood. Thanks.

Operator

And the final question comes from Robert Barry of Susquehanna. Please go ahead.

Robert Barry - Susquehanna Financial Group LLLP

Hey, guys. Good morning.

David D. Petratis - Chairman, President & Chief Executive Officer

Good morning.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Good morning.

Robert Barry - Susquehanna Financial Group LLLP

Thanks for fitting me in and congrats to Mike and Tom. A quick housekeeping item. I think you mentioned the target for investment spending is higher now. Did you or could you say what it is? And then my question was really on pricing. This fall off in Americas, especially given, I think, like the growth mix was in your favor, right, with non-res much stronger than resi. So, just curious where the pressure is coming from and to be clear on what you think is going to improve the pricing as we go forward. Thanks.

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Yeah. So, on the investment spending, we had incurred – there was about a $0.04 headwind in the first half of the year. We're looking at $0.12 in the back half of the year pretty much evenly split, Q3, Q4. So we're stepping up the investment spend. Some of that was planned for, but was delayed in the first half of the year. So, that's kind of how that's going to play out.

And relative to the pricing, we would, as I mentioned earlier, this quarter experience some unfavorable pricing in the resi segment. Would expect that to abate a little bit in the back half of the year and that's where you get the improvement in pricing.

Robert Barry - Susquehanna Financial Group LLLP

And what's driving the abatement?

Patrick S. Shannon - Chief Financial Officer & Senior Vice President

Less rebates and advertising, merchandising credits, those type of things. Discounts, I would say.

Robert Barry - Susquehanna Financial Group LLLP

Okay. All right. Thank you.

David D. Petratis - Chairman, President & Chief Executive Officer

All right.

Operator

That concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for closing remarks.

Tom Martineau - Director-Investor Relations

We'd like to thank everyone for participating in today's call. Please contact me for further questions. And for my last time, please have a safe day.

David D. Petratis - Chairman, President & Chief Executive Officer

Thank you, Tom.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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