Q1 2023 Resideo Technologies Inc Earnings Call

Participants

Anthony L. Trunzo; Executive VP & CFO; Resideo Technologies, Inc.

Jason D. Willey; Senior Director of IR; Resideo Technologies, Inc.

Jay L. Geldmacher; CEO, President & Director; Resideo Technologies, Inc.

Brett Kearney; Research Analyst; GAMCO Investors, Inc.

Brian William Ruttenbur; Research Analyst; Imperial Capital, LLC, Research Division

Erik William Richard Woodring; Research Associate; Morgan Stanley, Research Division

Paul Chung; VP & IT Hardware Analyst; JPMorgan Chase & Co, Research Division

Presentation

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 speaker's remarks, there will be a question-and-answer session.(Operator Instructions). Thank you. Mr. Jason Willey, Vice President of Investor Relations, you may begin your conference.

Jason D. Willey

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 at investors.resideo.com.Â

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 caution. 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 files. With that, I will turn the call over to Jay.

Jay L. Geldmacher

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 have 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 have created over the past 18 months by being a reliable partner to our customers.Â

For the 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 shut-off capabilities, the DT4 digital thermostat or 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 the heat pumps, hybrids, zoning and integrates with our underfed heating solutions. We introduced the HPC app and indoor control unit for heat pumps. This is part of our component portfolio supporting the growing EMEA heat pump market. 

We also launched the DX1 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 DX1 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 buying activity during Q1, and we currently expect limited broker activity over the remainder of 2023. While we are still carrying a 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 in 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 billion of annual savings. We have also made significant progress and are ahead of schedule on our El Paso, Texas distribution center consolidation. Most importantly, we have accomplished the no meaningful customer destruction. 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 non-spokeMCO products. We view the first work 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 of 2%. ADI continues to execute on expanding its e-commerce 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 of 2023, and e-commerce 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 and 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 integrated survey continue to point to growth in commercial categories in 2023 and healthy project backlogs. With that, I will turn the call over to Tony to discuss first-quarter performance and the 2023 outlook in more detail.

Anthony L. Trunzo

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 a 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.Â

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 remains strong and added approximately $28 million to revenue year-over-year. Offsetting this was a 12% decline in unit volumes driven by slower residential and demand compared with last year. Security revenue was lower due to continued softness in Europe and lower 3G LTE radio sunset migrations in the U.S. Our U.S. 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 that 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 the 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-Commercial categories, including fire and video surveillance, were up year-over-year but at lower 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 record 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's first quarter. Excluding $10 million of one-time First Solar 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, 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 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 product & 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 and 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 L. Geldmacher

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. We move 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.

Question and Answer Session

Operator

(Operator Instructions)Â Your first question comes from the line of Erik Woodring from Morgan Stanley.

Erik William Richard Woodring

I have 2. Maybe just on the first one. I believe last quarter, you guided to First Alert contributing about $120 million of revenue in the March quarter. And the press release shows it contributed about 100 and so about 20% below plan. I just -- is that right? And if so, can you just maybe help us understand what's happening with the First Alert business, anything that you believe we should know that you can call out? And then the second part of that, I'll just give you both, is you were still able to perform at the high end of your revenue guidance range. And so where did you perhaps see better-than-expected performance to offset that?

Anthony L. Trunzo

So Erik, it's Tony. Thanks for the question. So there's a couple of things about the First Alert business. It is a little bit seasonal. So Q1 is typically the lowest quarter. And we did have some softness in retail and particularly early in the quarter. Things got better as we rolled through the quarter, but we did see a little bit of softness. I wouldn't put it at the magnitude that you just flagged of $20 million. It wasn't in that scale, but it was a little bit soft. And we saw strength -- and the other place that was soft was the security business, which we flagged in our comments. Pretty much everywhere else, things were relative to our expectations, held up pretty well. The OEM channel stabilized during the quarter in terms of channel inventory, and the APAC distribution channel. It sort of ebbed and flow during the quarter. We had some periods where it's pretty strong. We have some periods where it sort of ebbed back again, which is a little bit of what we find ourselves in today with respect to our outlook for Q2. We haven't seen a clear directional change there yet. But pretty much all the rest of the business performed as we expected or a little bit better than we expected.

Erik William Richard Woodring

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 go 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.

Jay L. Geldmacher

Thanks, Eric. On the call, I'll attempt to do some Honeywell explaining. And then obviously, we're happy to follow up with people and provide detail. But this is the first quarter we've guided to data below operating income. And the reason that we historically stopped at operating income is there's always been variability in the accounting impact of the Honeywell liability in any given quarter versus the very stable, very predictable, $35 million a quarter in cash. And that variability always showed up in other income. So it was below the operating income line. When we're talking about GAAP EBITDA, non-GAAP EBITDA, we're talking about earnings per share, those things start to have an impact again. And we're managing it. This quarter, the accrual we took was $41 million. I think historically, as we've had it in the 40s a couple of times in the past, it's been that high. And it really represents a true-up from Honeywell of their estimate of the 5-year cost of environmental maintenance and remediation.Â

So they'll go through all of the properties, all of the overall maintenance costs, all of those things on a regular basis, and they'll update them. And you can have inflation. You can have changes in any given site, those kinds of things that will have an impact on a quarterly basis. What I want to be really clear about is that it has no impact on the cash dynamic either in the short term where it's $35 million a quarter over for the life of the agreement, which is for 25 years, 25 of which still remain. So it doesn't point to us having to pay ultimately in aggregate more money to Honeywell, either in short term or in the long term. And I think when Tony was talking about in our remarks, you made that point that that is capped, and that's, we know what that is, and that's predictable.

Operator

Your next question comes from the line of Brett Kearney from Gabelli Funds.

Brett Kearney

With the balance sheet, still pretty good -- still in good shape. And it sounds like there's some positivity from some of the commercial, I guess, contractors, and integrators you interact with. Can you talk about maybe potential for further ADI bolt-on acquisition opportunities in this environment? Are they still available? And kind of what's the appetite on your end for doing more in that front?

Anthony L. Trunzo

So they are still available. As we've talked about before, the ADI team has a pipeline. They're in regular dialogue at any given time, a couple to a handful of potential targets. And we've done a really good job of being disciplined around price and frankly, around timing. And as opportunities come up, we will continue to do those kinds of deals. But the reality is, with the cost of capital having gone up, our view is valuations have probably come in a little bit, and sometimes, when those kinds of dynamics happen when you're trying to do a consolidation play, you have to get sellers to adjust to a new reality from a valuation standpoint. And I think maybe we've seen a little bit of that in terms of timing.Â

But I mean, we continue to look at them. And to the extent that they make good financial sense from an upfront cost standpoint, these things almost always make really good sense in terms of us being able to consolidate them into ADI.

Jay L. Geldmacher

Yes. I think Tony's comment is spot on, and I just would add that I think because of some of the dynamics in the market out there that has been a little bit more of a sense of reality in terms of valuations. And so it gives us an opportunity to scrutinize it and determine if it makes sense now versus holding on for a period of time before we do it. But the ADI team, bottom line, have done a really nice job of selecting their bolt-ons. We're pleased with their progress.

Operator

(Operator Instructions)Â Your next question comes from the line of Paul Chung from JPMorgan.

Paul Chung

So just on free cash flow, after heavy investments in inventory over the past 2 years to kind of fund 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 the 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? I have a follow-up.

Anthony L. Trunzo

Paul, thanks for the question. I guess the short answer is, in order for us to get to that target that we just laid out in terms of bringing that cash cycle in, the significant majority, if not all of that has to come from inventory. We're disciplined about how we pay suppliers. So the AP lever is not one that we pull. Our DSO are relatively stable. They've ticked up a couple of days here, but they are relatively stable. So the focus is on bringing inventory down in dollars between now and the end of the year to get to that level.Â

And you're right. That gets us down to those kind of 2021 levels. It doesn't get us all the way to the kind of late '20, early '21 levels that were lower than that. And I guess I'd highlight that those were probably artificially low. We were coming out of COVID. We had -- our fill rates were lower than we wanted them to be. Our delinquent backlog was higher than we wanted it to be. And it was sort of the beginning of the supply chain challenge. We just leaned out very heavily at that point. So I'm not sure, at least in the short or intermediate term, we could expect to get back to those levels. But I think to be able to take the 10 days out of the cycle between now and the end of the year is doable, and as I said, we're exceptionally focused on.

Jay L. Geldmacher

Yes. And I would add to that. There's no doubt about it. We have a heavy focus on that. The whole organization does. And as we've indicated, not just today, but in February, we talked about too, with -- I'm very pleased to say that with the supply chain situation becoming significantly better. It's not all cleared up and gone but much, much better. There's more predictability than that. We're able to run our operations a little differently because we don't have to have inventory hung up. And so I'm excited about the opportunity here, and we wouldn't have put that target out if we didn't feel pretty strongly about this. And we know how important it is for a whole variety of reasons. So the team is heavily focused on it, and you'll hear more about it.

Paul Chung

Yes, that would put your cash in a great place. That would be fantastic. And then just a follow-up on the kind of lower component costs. You mentioned were kind of minimal in the quarter. How do we 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, 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 certain product lines? And that's it for me.

Jay L. Geldmacher

Thanks, Paul. Yes. I mean, we're going to continue to see opportunities and be able to maintain things on price in terms of our input costs that we haven't been able to do for probably closer to 2 years where we were paying a higher price because of the way the supply chain was. So there's definitely -- that's in our grasp, and I think that will continue to improve further as the year goes on. We've also talked about freight. Freight is significantly less than it was because of all the dynamics that took place in the last 2 years. So that's important. We had to spend a lot of money, as many companies did have broker buys last year. And as I indicated, we had much, much less, and we continue that trend throughout the year. So there's a whole variety of opportunities there that to say I'm not just pleased about it, but I can tell you my supply chain team is very excited about the opportunities there.

Anthony L. Trunzo

Yes. Paul, a couple of things. Maybe. The input costs in Q1, both from an inflationary perspective, both in terms of material costs and, frankly, labor were significant compared to last Q1. And that's what you saw. And our price realization was able to offset a fair chunk of those costs, but we didn't get a margin on that price realization. Our outlook for the second half of the year points to improved margins and improved profitability. And it's driven by what we see as sort of the lapping of some of those headwinds and the opportunity to maybe get a little bit more from the -- in terms of value engineering, in terms of supplier management, those kinds of things that should help us to bring some of those costs down in the second half of the year.

Jay L. Geldmacher

The other thing I was going to add was that supplier lead times also have significantly been reduced. So that helps in terms of the management of our inventory, our own internal. We have an investment in '09, and our forecast improving, I think is really important, and we're excited about that. And you've heard us talk not just in the recent months but really for the last 2 years of how important and upfront our customers are with us and a relationship building that we've done in the last few years. So we're much closer to our channels than I think we've ever been, and it's just continued to improve. So that's why it is that important to this discussion because we're that much closer to the finger on the pulse of what's going on out there with our customers and getting good feedback from them.

Operator

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

Brian William Ruttenbur

Just a couple of cleanup questions. You stated, I think, in the last quarter that the 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 levelled 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.

Anthony L. Trunzo

So I'll make a few points. First of all, the point we were making last quarter was that the financial impact on us of the shakeout of HVAC distribution channel inventory, to be precise, was likely to kind of trough out in terms of the negative impacts and headwinds in Q1. We still think that's the case. That channel, as I mentioned in answer to another question, it's kind of ebbed and flowed. We've had some, like I said, in the last 4 months, we've had some strong periods, and we've had some periods where orders have slowed again. And so it's a little bit hard, and it almost gets to a customer-by-customer level in terms of where people are relative to their desired inventory and sort of how they're feeling about the market. It feels more dynamic, maybe, than it has been.Â

And we haven't -- I wouldn't say that we've seen that consistent up arrow yet in terms of consistent kind of demand growth there. Having said that, we don't expect an inventory sort of (inaudible) distribution channel impact that would be significant in terms of our outlook for Q2 for the remainder of the year. The other point I want to make is the OEM channel, which also had excess inventory, that does appear to have leaned out and reached the levels that we and our customers expected them to get to. So we do see a little more of a sort of dynamic flow claim from our order book to the end customer without any dynamics embedded in that channel.

Jay L. Geldmacher

And I'll also add, I think we've continued to level out through Q2 and also -- and I think I may mention of it. Our delinquent backlog is coming down. It's not quite where we want it to be yet, but this come 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 William Ruttenbur

Yes. And then just one other follow-up question briefly. Roughly, at least in my notes, residential is about -- of your end customers, about 1/3 and commercial is about 2/3 roughly. Have you seen that kind of change recently, where commercial -- everything that I'm picking up on is driving very fast still, and residential seems to be going in the opposite direction. Can you talk a little bit about the mix of your kind of end customer?

Anthony L. Trunzo

Yes. So that mix relates to the ADI business, the distribution business. And commercial has held up meaningfully better than the more residentially focused parts of that business. The residential focus parts are the residential AV and the residential security, and they were down in Q1 while our commercial business did grow in Q1 was lower than what we had seen, but it did grow in Q1. But just as a reminder to everybody, the Product & Solutions business is almost entirely residential. So there's in that business, I think maybe the mix that you're thinking about is we've pointed to new construction being somewhere in the 20% zip code and repair, remodel and more in the 80% range. But it's heavily residential.

Operator

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

Jason D. Willey

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

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