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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Ladies and gentlemen, at this time, I'd like to welcome everyone to the Resideo Technologies Third Quarter 2020 Earnings Conference Call. Today's call is being recorded. [Operator Instructions].
It's now my pleasure to introduce Mr. Jason Willey, Senior Director of Investor Relations. Mr. Willey, you may now begin, sir.
Good morning, everyone, and thank you for joining us for Resideo's Third Quarter 2020 Earnings Conference Call. On today's call will be Jay Geldmacher, Resideo's Chief Executive Officer; and Tony Trunzo, our Chief Financial Officer.
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 vary materially from those on the forward-looking statements as a result of a number of factors, including those described from time to time in Resideo's filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements.
Additionally, during our call today, we will 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 identify the principal risks and uncertainties that affect our performance in our annual report on Form 10-K and other SEC filings.
I will now turn the call over to Jay.
Thank you, Jason, and good morning, everyone. During the third quarter, we saw a meaningful improvement in demand across our markets. This demand enabled us to leverage our extensive product portfolio, unmatched relationships with the professional channel and the broad reach of our ADI distribution platform to deliver a significant improvement in the year-over-year and sequential financial results.
At ADI, revenue grew 11% year-over-year in the third quarter, reflecting another quarter of outperformance relative to the markets it serves. The ADI team has a long track record of executing on value-enhancing growth initiatives and a well-defined strategy for driving continued outperformance.
Within Products & Solutions, we grew revenue 12% compared with third quarter 2019. We saw underlying strength in each of our end markets, which translated to top line growth and gross margin expansion.
Across the business, COVID-19 dynamics shifted from a meaningful headwind in the second quarter to a tailwind in Q3. As we indicated on our Q2 call, underlying demand and customer behavior trended positive as Q2 progressed and into July. This momentum accelerated as we move through the third quarter. People continue to spend more time in their homes, which we believe is creating increased attention on the home and a desire to invest, driving demand for renovation and repair projects and home security.
With leading solutions and distribution reach across home comfort and security markets, our business is well positioned to capitalize on the current positive market trends, which we believe have durability beyond 1 or 2 quarters.
Looking back on my first 5 months of Resideo, there's been significant progress on driving operational improvement and an accelerated focus on innovation. We solidified the senior leadership team, adding individuals with proven track records of delivering efficiency improvements, cost discipline and growth. We reorganized Products & Solutions to bring needed operational focus, while at the same time, better structuring the organization to move quicker to address customer needs, product innovation and new market development.
The strengthening and reorganizing of our teams are critical to unlocking long-term value at Resideo. In August, we added Jeff Frank as Senior Vice President of Product Innovation to create cohesion across the organization around new innovation in our product road map and engagement in strategic market development. The innovation organization is new within Resideo, and Jeff and his team bring fresh perspective to our technology development, join on a multi-decade track record of successfully bringing new products to market. The formation of the innovation team and their focus on unifying software, platforms and user experience across the business is critical to ensuring our position as a leader in enabling the connected home ecosystem.
In October, Phil Theodore, who joined Resideo earlier this year to lead our transformation efforts, took on the role of President of our Products & Solutions segment. Phil is the hands-on operationally focused leader that is essential for executing on the transformation of this business, leading the efficiency efforts and positioning the business for sustained growth. As we look to accelerate product development and bring historically siloed product lines together as one business.
We have reorganized Products & Solutions to integrate engineering and product line management. These changes are designed to foster collaboration across the entire product portfolio and establish linkages critical to bringing innovative new products to market quickly and cost effectively, while ensuring we are aligned with the needs of our customers.
As we make these organizational changes, we recognize the need to maintain our focus on bringing operational discipline and accountability to the business, while driving to sustainable long-term revenue growth.
I view transformation as a continuous journey and not a discrete project or program. Our transformation team now reporting to Tony will continue leading this crucial work at Resideo with a focus on ingraining these critical values into the culture of Resideo.
I have focused much of my time over the past few months on directly engaging with senior leadership of our key customers and partners. I believe building these relationships will allow us to better understand our customers' needs, identify opportunities for collaboration and inform our decisions around product development, marketing support and other critical areas.
I have also challenged the team to accelerate our engagement related to partnerships and strategic relationships. While we have a broad suite of products in the residential solutions market, the market itself is substantial. And there's meaningful opportunity to partner in areas where we are clearly differentiated or we can leverage the innovations of others to create greater value.
With that, I will turn the call over to Tony to discuss our third quarter financial performance in more detail.
Thank you, Jay, and good morning, everyone. Consolidated revenue for the third quarter was $1.4 billion, an increase of 11% compared to the prior year. As Jay indicated, we saw strong demand across the business during the third quarter. Q3 gross margin of 27.2% was up approximately 200 basis points from Q3 last year, primarily due to improved cost absorption on stronger revenue and cost savings from transformation programs.
Selling, general and administrative expenses for the third quarter totaled $239 million, down 4% from Q3 last year due largely to net savings generated from our cost-reduction initiatives as well as COVID-19-related cost savings.
Higher revenue, improved gross margin and lower spending resulted in an operating profit of $131 million for the third quarter compared to $59 million in the prior year. GAAP net income for the third quarter was $75 million or $0.60 per fully diluted common share. Consolidated adjusted EBITDA of $188 million was up 65% compared to the prior year.
ADI revenue of $790 million increased 11%, which included an approximate 2.8 percentage point benefit from acquisitions. Demand returned across the business, particularly for products serving the residential market in North America and for large project business. While ADI experienced some COVID-related disruptions to its branch network during Q3, the impact was much less than the second quarter and more than offset by strong e-commerce revenue. ADI has stepped up its investment in e-commerce, and we expect these initiatives to aid revenue growth and margin improvement moving forward.
ADI segment adjusted EBITDA was up 8% to $52 million due to higher revenue and a continued focus on cost management. These positives were partially offset by unfavorable product mix and the increased investment in several long-term strategic initiatives.
Products & Solutions Q3 revenue was $572 million, up 12% compared to last year due to improved end market demand, particularly in the security and comfort markets. Products & Solutions exited the quarter with backlog well above typical levels, which reflects continuing strong demand as well as COVID-19-related impacts on our manufacturing operations and supply chain.
Products & Solutions segment adjusted EBITDA of $136 million was more than double Q3 of last year. The improved performance reflects higher revenue, sourcing and productivity initiatives and cost reductions.
Beginning with Q1 2021, we will report our corporate costs separately. This change will better align accountability and authority, give a clearer view into the operational performance of the 2 segments and increase accountability of the management on corporate spending.
Consolidated cash from operations for the third quarter was $21 million, up $54 million year-over-year due to improved net income and an increase in accrued liabilities. As expected, cash from operations in Q3 was impacted by higher receivables as sales grew sequentially.
At the end of Q3, Resideo had cash and cash equivalents of $260 million, total outstanding debt of $1.3 billion and $200 million undrawn on its $350 million revolving credit facility. On October 30, we made our regularly scheduled $35 million reimbursement agreement payment to Honeywell, and we also made a $35 million payment that was originally due in April that had been previously deferred.
We remain focused on driving costs lower, accelerating innovation and ingraining a culture of continuous improvement and growth. Over time, we will move away from specific cost-reduction programs and instead focus on making efficiency and cost savings part of our DNA, with results that will be visible in improved margins and overall financial performance. As it relates to our current transformation program, we now expect between $40 million and $45 million of net savings for the full year 2020. We will provide more detail on future transformation initiatives with our Q4 results.
Given the improved visibility in our business, we are reinstating guidance for the fourth quarter of this year. We currently expect Q4 revenue in the range of $1.36 billion to $1.41 billion, GAAP operating profit in the range of $130 million to $140 million and adjusted EBITDA in the range of $180 million to $190 million. Our October results and the healthy demand we continue to see across the business support the outlook we are providing today. However, rising COVID cases around the world create additional market and operational uncertainties. Our Q4 outlook does not factor in new restrictions that could materially impact customer activity, industry supply chains, our manufacturing facilities or our ADI branches. As always, we will prioritize the safety of our employees over all other considerations.
As part of our budget process for 2021, we are evaluating incremental growth investments across Resideo. At ADI, these investments will include systems enhancements, e-commerce initiatives and targeted M&A. Within Products & Solutions, investment will be focused on driving new innovation and new product development. Investment in these areas will be reinforced by the recent organizational changes and leadership additions that Jay discussed. We will dive deeper into these areas when we report our Q4 results and at our Investor Day that we plan to host in early March.
As a reminder, beginning in 2021, we intend to deemphasize non-GAAP measures and focus on operating profit, cash flow from operations and other GAAP measures. In our view, GAAP presents 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.
Thanks, Tony. While we continue to closely monitor COVID-19-related risks in our operations and supply chain, we are encouraged by the strong customer demand we are currently seeing. As we move through our 2021 planning process and continue to refine our long-term strategy, we are focused on rightsizing our cost structure, driving efficiencies to deliver further gross margin enhancement and accelerating our new product introduction process to ensure we are positioned for long-term growth. We intend to capitalize on the current demand tailwinds across our markets as we execute on our transformation efforts. The current business strength opens opportunities to accelerate the changes and investments we are making to drive innovation and efficiencies in the business. We look forward to providing more details when we report our full year results in February and at -- and in an Investor Day in early March.
As I look back at my first 5 months of Resideo, I'm even more encouraged by the opportunities that I see for long-term value creation. While there is meaningful work to be done, I believe we have an incredibly strong foundation. This foundation, combined with ongoing transformation efforts and the new talent we are bringing on board, give me tremendous excitement about Resideo's future.
In closing, I would like to thank our employees for their dedication and effort over the past quarter. Across the organization, people have stepped up to ensure we meet the needs of our customers, while at the same time, embracing the changes necessary to create a platform for long-term sustainable success for Resideo. This concludes our prepared remarks.
And operator, we are now ready for questions.
[Operator Instructions]. And our first question will come from John Lovallo with the Bank of America.
The first one is, it looks like the transformation programs really started gaining traction in the quarter. And it looks like you took up your cost savings targets. Can you just help us understand where you saw the most traction in the quarter and where the incremental opportunity is?
Tony, you want to comment on that?
Yes. John, so as with any transformation program, the first place you see benefit is in the cost structure. You see it in SG&A and a little bit in your fixed overhead in your -- in COGS. The -- moving forward, the benefit should translate more into the COGS line and eventually then up into the revenue line as you start to do -- as you start to implement sales activation programs, and you see the benefit of those start to take hold. It just takes a little bit longer.
So the number that you see -- the number that we just gave you, that $40 million to $45 million, a significant majority of it is in operating expenses, so is a significant majority of the costs, by the way, when you look at it on a GAAP basis. And that's why we gave the net number.
Moving forward, as I said, we're implementing some programs with respect to integrated business planning and some other initiatives that should help significantly on the gross margin line. And then in terms of sales activation, things like our profitability, management office and other initiatives, we think over the next few quarters, will show momentum as well.
Okay. That's helpful. And then the big surprise in the quarter from where we sit at least was that 23.8% Products & Solutions margin. And what we're trying to figure out here is sort of the sustainability of that. It looks like the fourth quarter would imply something north of 20% as well. So we just kind of wanted to dig a little bit more into what were the biggest drivers there? Is this 20% sort of a good sustainable run rate number? Any thoughts on that would be helpful.
So John, that gives me the opportunity to tell you that we will give a clearer view as to long-term metrics and long-term expectations with respect to things like margins at that Investor Day that we referenced in early March. We're still grinding through a long-term plan that would indicate what we think is not only sustainable, but over time, trending upward to what we think is ultimately achievable.
The margins we saw this quarter, there's nothing in the quarter given the revenue number that would suggest that it's not sustainable. In fact, product mix was slightly unfavorable in the quarter. We got really good operating leverage off of our fixed costs and that's a significant benefit in a business like this. To the extent we continue to see good revenue performance, there's nothing to suggest that, that margin level isn't sustainable.
I'll also add, John, that the transformation office that we've created within the company here is really something that margin enhancements is top of mind. And as I said and as Tony said, this is becoming part of our DNA. This is not a short-term type thing. So margin enhancement will always be a focal point for the company as we move forward, and there's a group of people that's all -- that's kind of their life blood and what they do within the organization.
That's good to hear. If I can just squeeze one more in here. On the ADI side, revenue was up nicely, 11-ish percent. Margin was flat. It seemed like there was some investments that were made in the quarter for growth. Can you just help us understand maybe what those investments were and maybe the magnitude of that and if you think those are going to persist?
Yes. So as we said on the Q2 call, there's -- ADI is a business that deserves more investment. Rob and his team have done an absolutely incredible job with that business over the last couple of years, really operating on a shoestring. And we're changing that. We are investing more aggressively in some sales initiatives like outbound telesales. We're investing in e-commerce in a meaningful way. We'll be investing in the underlying systems in a meaningful way.
So yes, those things will continue. Having said that, we still expect the ADI business to continue to perform at the margin level consistent with what it's done historically. These investments are designed to -- really to drive the business forward from the strong foundation that it sits on today.
Our next question comes from Ian Zaffino with Oppenheimer.
Can you guys just talk a little bit about -- you mentioned mix on the product side. Can you just get a little bit deeper into that? Or maybe just how does security versus comfort and care do?
Yes. Ian, we're not going to dive deep, deep into kind of customer-level margins or even necessarily margins by the old segments, which, by the way, we're in the process of, as we talked about, knocking down those silos and really turning them into product lines in a more consolidated and cohesive P&S environment.
Having said that, we indicated that there's -- we have meaningful backlog at this point because of demand and because the supply chain is somewhat tight, which means that we have, at some level, prioritized our OEM business, which is -- part of that is in security, part of that is in the old RTS business. But those -- that OEM business tends to have somewhat lower margin than what the sort of normal run rate business would have.
Yes. And I'll add to that. Just from the comments that we both -- Tony and I both made, and I think -- and you'll hear us talk a lot more of that as we move forward in the future. But this -- eliminating the silos that were created with the individual product lines, product groups segments within Products & Solutions, we're going to get a lot of efficiencies, productivity, but with -- and very importantly, innovation because I'll be able to look at it in a different way through a different lens and total innovation across all the products within P&S. And we'll get a lot of efficiencies, productivity, as I mentioned. But again, I'm really excited about -- or just as excited about the innovation that this is going to provide across those segments.
Got you. So basically, when you referred to mix, you were talking more about more OE versus aftermarket versus product line?
Yes. That's right.
Okay. Okay. Good. And then can you maybe just give us a -- your thoughts on ADI and products. How they're working together? Is there a greater concerted effort to have them work together? You talked about breaking down silos, and I know you referred to that on the product side. But also what about unlike business divisions as well? Like is there any opportunity there? Or is there anything we should expect?
Yes. I think we have a real opportunity to have a tighter collaboration between ADI and Products & Solutions group. And looking at what -- as Products & Solutions looks at their product road maps in the future and then at the same time, discussing what can be done further with ADI. And so that's happening. And that comes back, as you just mentioned, and I mentioned about the breaking down of silos. And I know that two groups are now working even closer together, and we're encouraging that in a big way. So I expect more opportunities there.
Ian, to put a super fine point on it. Our P&S business' largest customer is ADI.
That a great point.
And we have not -- and Jay talked about managing relationships and building relationships at executive and senior levels with our major customers. That is as important at ADI in terms of building that connectivity as it is in any of our other major customers. And we're well on our way in that regard.
[Operator Instructions]. Our next question comes from Craig Irwin with ROTH Capital Partners.
First, congratulations on the strong results. I wanted to ask a little bit about channel contribution to the strength that you saw this quarter. Was there much variance between your traditional distribution OEM and factory direct customers? And can you maybe comment on whether or not some of this might have been catch-up spending for projects that were delayed in the COVID environment we experienced starting this past March?
Sure. Jay, I'll start and then you can pop in as well.
Yes.
In terms of breaking it down by channel in that way, Craig, we're not in a position to do that. I think -- as I said earlier, when you look across the business, the OEM business is somewhat less profitable than the aftermarket business. It's somewhat less profitable than some other parts of our business. But going deep into the channel isn't something we're in a position to do. And mainly, that's because we continue to really try to drive a unified view within P&S of their product development, of their innovation. And as we do that, those silos, they're going to blur as well.
As it relates to how much of this was driven by sort of channel restocking and all that sort of thing, we -- it's obviously -- it's an imprecise science to try to figure that out. But what we're seeing right now, after 5 months -- 4, 5 months of sustained strong demand across the board, pretty clear, it's well beyond channel restocking and that there's a fundamental increase in demand throughout the -- basically throughout the entire home connected ecosystem that we're serving.
So that's why the comment was made that we see durability here beyond just the next quarter or two in terms of the level of demand because we think there's really been a fundamental change. There's real strong indications if that's the case. And one of the strongest is our -- is the fact that we continue to maintain a significant backlog.
Yes. I would agree with Tony on that. And we try to triangulate what's going in market just like you guys do and look at how everyone is performing that services this space. And I think that -- and when you look at that data and those types of results across the board, I think that just reinforces everything Tony just said.
Okay. Excellent. So then if we take an approach of maybe summing the March and the June quarters' results together, your revenue on a combined basis was down just a tad year-over-year, but your EBITDA was up something in the low teens. Clearly, there's leverage to what's been done in the last 6 months of the last year. Can you maybe expand on where this leverage is coming from? And specifically, how does this get amplified over the next couple of quarters? Are there discrete actions that we should watch for or monitor to understand the proportionate impact.
So Craig, I didn't track the Q1 to Q2 commentary you just made.
Add 2Q and 3Q together, compare them for 2020 over 2019. It's down just a tad, but your EBITDA is up 13%.
I see. Yes.
So you're getting -- you're definitely getting leverage on the EBITDA side. And you talked about progress on the SG&A side. Margins are obviously coming through. I just really -- I'd appreciate it if you can give us some more color on some of the specific projects or specific actions that are driving that leverage? And what should we look for as milestones to see similar execution over the next number of months and quarters?
Sure. So I see where you're going. I haven't done exact -- the exact math you're talking about, but it doesn't surprise me at all. And it kind of goes back to the first comment I made.
When you do these kinds of transformations, the first level of savings comes from SG&A and fixed overhead. And a lot of those actions were taken at Resideo this past spring and into the summer. And we're seeing the benefits of them now, and that's why the -- on a net basis, the benefit of our transformation programs was skewed toward the second half of this year. But it really sort of is concentric circles of opportunity. The first is that G&A. The second is in the factories and just getting your -- getting the profitability and the gross margins up. And then the third piece is that sales activation that I spoke about.
The factory piece right now is benefiting from the reality of strong demand. Absorption is a -- it's a powerful thing, and we're seeing the benefits of that. The -- that's not the end of that story by any stretch of the imagination, though. Because, as I said, the -- there's an initiative going on inside of P&S that we're referring to as integrated business planning, well, that's the name of it. That we think has the opportunity to continue to drive margin and efficiency.
Look, the business had a pretty heavy load of SG&A coming out of the spin and over the last year to 1.5 years. Getting that cost structure right was step 1, but it's not, by any means, the only step.
And in terms of what you can look for moving forward, we'll have this margin conversation every quarter for a long time, I'm sure. And as I said in my comments, we're no longer talking about individual discrete programs. We're talking about really building into the DNA of the business a focus on costs. And that gets to cost accountability and making sure that every dollar of spending in the organization has an owner who's accountable for it and is proactively making the decision to spend that dollar. That's a relatively new concept within certain parts of Resideo, and we've made tremendous progress on that.
And then on the margin side, as I said, we're not satisfied by where we are, and we're going to continue to focus on expansion.
Yes. And I'd add to that, just to -- I think it's really important to reemphasize because I think it's definitely -- it's a new way for this company to operate, and we're excited about it. But the discrete projects that had been implemented as part of the transformation efforts before I came onboard, before Tony came onboard, we're in-flight and then we helped accelerate those. And those were, as I said, discrete projects.
But the cultural change and the things we're pushing in the organization for, what I'd say, long-term DNA transformation that just becomes part of everyone's way of doing business is what's really exciting for me and the organization because it's -- it will be continually transformational for the business for not just margin enhancements, but many -- really all the functional areas of the entire business. And just that way of thinking, that way of operating on a day-to-day basis, and we'll be -- we'll look forward to being able to share more of that with you as we go on, but it's not going to be just 1 discrete program and then overall done, and then we don't worry about that anymore. It's going to be part of what we are all about, and we're driving that in the organization. And as I said, we created a transformation office to help champion that.
And I want to add one other thing, and this is my soapbox, Craig, you heard me on the first call, and I'll take the opportunity to do it again. That's why we're going to GAAP results for a lot of the focus of our reported earnings.
When you get to add something back, there's this element of it being somehow you get a hall pass for the spending. We're not doing that anymore. The organization, I think, understands that very clearly and frankly, has responded very positively to it. But that accountability for spending is -- it's an incredibly powerful cultural change, and it drives incredibly powerful results.
Great. And then last question, if I may. Priorities for new product development. You guys are obviously completely reinventing the approach and picking your priorities carefully about where you spend your dollars. Can you maybe share with us what you see as top priorities for new product development? Are there areas where you think the portfolio really does need to be refreshed to see better traction? Or are things just more broadly spread across the portfolio and a little bit more sort of opportunistic?
So I'll jump in and Tony, please add. We -- as Tony mentioned as well as I did, that we're going to have an Investor Day in March, and we will talk about really our total product strategy then, and we'll be able to share -- we're going to answer a lot of the questions that are behind what you just asked.
And -- but also -- but I also will say that the innovation office that we've created that I'd talked about in my section is going to -- as we knocked down silos, as I mentioned, take a look at the entire ecosystems of all of our products that we offer and the innovation and technology group to help drive the future product technologies, product strategy, leveraging the great base of products that we already have, but accelerating innovation, accelerating new technology. And that's not just internal within the company, but we're also -- we're looking at what -- and I mentioned it too, partnerships -- strategic partnerships together to see what more we can do to fulfill our entire product road map -- product strategies as we move forward.
Yes. Craig, we'll have more to say about that as we move forward. I think the decisions around that are -- as I said before and as Jay talked about in terms of changing the way P&S is organized, I'd encourage you guys to think less about security and RTS and comfort and more about what's the holistic product line opportunity that is in front of Resideo. And how can we respond to the market needs by putting our investment in areas where we have a meaningful opportunity to be competitive, that have good growth to it and have good margin opportunities associated with it. That's a process we'll never be done with because that changes over time. But moving forward, I think we'll be in a position to give you a little bit of a clearer view as to what those priorities are going to look like.
Great. Congratulations on the solid progress.
Thank you.
Thanks, Craig. Appreciate that.
Thank you. That concludes our time for Q&A. And with that, we'd like to thank you for attending the Resideo Technologies Third Quarter 2020 Earnings Conference Call. You may disconnect your phone lines, and thank you for joining us today.