All right. I am Dan Stratemeier. I work in the Jefferies Equities division. I am honored to introduce for the first time, I think, at a conference, Rob Aarnes, the new CEO of ADI.
Hey, everyone.
Kevin Prush, what is your official title, Kevin Prush? Global head of financial planning?
Global head of strategic financing.
There you go. I was close.
Thank you.
Well, again, congratulations on separating successfully.
Thank you.
Why don't we just talk a little bit high level? Why don't you give us an overview of your business?
Rob Aarnes, before you jump in, let me just take an opportunity to just remind everybody that we've got a disclaimer that we may be talking about forward-looking statements today. We have this disclaimer on our website and in our investor filings.
There you go. Good job.
Didn't want to miss that.
Gotta do that, Dan Stratemeier. Gotta do that.
Just tell us a little bit about your business, what makes it special, how long you've been there, and maybe what has or has not changed, and what you could potentially do differently now as your own standalone company.
Yeah. As you said, Dan Stratemeier, these are very exciting times for us. ADI Global Distribution has been in business for now 3+ decades. Today, as it stands, we are the largest specialty distributor of commercial security, fire and life safety, and residential AV products, certainly here in the Americas, with also a strong business in Europe, and then presence in actually Australia and Malaysia as well. Business is divided 70% commercial, 30% residential. Residential right now is, everybody knows based on some of the macros, they're a bit softer for us, more of a challenge. The commercial side of the business is growing really nicely and that's good because that's the core part of the business. Up until August 4th, we've always been part of a products company. We're longtime with Honeywell.
We were the only distribution business as part of a $40 billion manufacturing company, so capital was hard to come by, but we thrived. We got gritty, and we figured out how to operate really efficiently. Then in October of 2018, we spun out from Honeywell to be part of Resideo. Still a manufacturing-focused organization, but at that point, at least we represented half the revenue. So we were able to really start investing in the business the way we needed to. But in a lot of cases, we were still playing catch-up. But again, really supported by the Resideo team, thrived. But I think everybody knew from internally to our investors that these two businesses didn't belong together.
We finally got the stars to align, negotiated with Honeywell, and we were able to spin from the Resideo business just back on August 4th, ring the bell, and it was a bit of a Liberation Day for us, if you will. I think we called it Independence Day. I think it was the right time. I don't think. It was definitely the right time. We've been asked this quite a bit. Size, scale, the actual geographical footprint we have, the actual offering, the market share positions we have, and the categories that we play in, this was absolutely the right time. The big difference now, as you mentioned, Dan Stratemeier, is now we're able to actually set our own strategic priorities, allocate capital in the way that it's going to benefit ADI and ADI alone, as is Resideo.
They had the same kind of challenges every year to depend who was going to be able to do the next big deal, allocate capital appropriately based on the highest return, and we don't have those challenges anymore. Then, one of the biggest benefits is conferences like this. We get in a room with investors, people that are interested in the business, and we are only talking about ADI. We're not sharing time, talking about ADI, talking about P&S, different go-to markets, different sets of KPIs. I know in the long term, that will help us out as well. That's why this kind of opportunity to be our standalone company is the right time, and we're going to take advantage of it.
Despite not having the capital you may have wanted and being a part of a very large conglomerate and then another company, you've grown tremendously since 2013 or so. I guess that's around the time you came to-
I got there in 2013, yeah.
2013. How was the company enabled to grow so significantly when it essentially was capital constrained over that timeframe, and what does that scale advantage do for you and your customers?
I will tell you, there is one very simple formula for us as I go back to 2013. Certainly, Kevin Prush was here at that point, too. This was a business that you just came out of the tough 2008, 2009 timeframe. It was very margin-focused, and that is fine. But the ability to grow organically and really take share and get a lot grittier about that was, that culture just was not in place at the time. We started out, we put an organic growth strategy in place that was super simple to understand.
In fact, we have talked about this. It was called 4321 equals 10%. That was our organic growth strategy. It was something that everybody in the organization, which was something we wanted to make sure was in place from if you were in the warehouse, the DCs to the stores, you could explain it.
4%, we wanted to grow by taking market share, and we had specific sales programs to do that, and then 3% from new product introductions, 2% from new customer introductions, and then 1% from GDP. Now, the math was not perfect across those, but when you are talking about an organization with 1,500, 1,800 people, that was something that they could get behind. And we rewarded the teams for being aggressive, taking share, understanding how much wallet share we had at the individual customer level, tracking those things, and then rewarding, again, our sales teams and our different marketing organizations from taking share and doing it aggressively. Along the way, back then, we were more heavily concentrated in residential.
Along the way, we said, "Hey, listen, the real growth is in commercial, but we've got to build some capabilities, and we got to do it without a lot of capital." We started to engage larger security integrators, in some cases, that were underserved, started to build internal capabilities around project registration, project design, not a lot of investments to be able to do that. Then really pride ourselves on being quicker, the easiest to do business with, I think, over time. Then bringing on some of the larger enterprise suppliers that really liked the service that we were providing. Then over time, you saw the business shift.
We didn't lose any ground in residential, but we started to gain a lot of share in the commercial space, and that's how we've more than kind of, I guess, tripled the size of the business since the time I got here.
It's a pretty stable revenue stream or growth organically on the commercial side in particular. What are the drivers that make it such a stable business?
Two things really, especially on the commercial side. One, technology is really the biggest driver of kind of the end market, the commercial security, ProAV, and Datacom businesses. As you think about a lot of suppliers, a lot of integrators, and a world that is committed to building a safer, smarter, more connected space, and as technology helps end users be able to do that, protect patrons, consumers, students in college campuses, our suppliers, they know that, and that's been driving demand. As technology has improved over the years to be able to do, provide that greater level of protection, it's not uncommon for a string of banks, college campuses, the verticals that our integrators play in, to rip out systems that are three to four years old because technology has advanced, and then put in, obviously, newer systems.
I would say as I look at our entire commercial part of our portfolio, the overwhelming majority, 70%-80%, is driven by technology advances.
That's idiosyncratic of the business cycle, as you're-
Correct. It doesn't depend on commercial construction, and that's a beautiful thing. Then I would think secondary to that is this just technology convergence. Systems now, security systems, ProAV systems, Datacom systems all on the same network in the same building or infrastructure has driven a great opportunity for distributors and integrators to be able to win the entire job. Whereas, 10 years ago, you had IT integrators, you had ProAV integrators, security integrators that really could only play in their space, in their lane. Now, with convergence, we've been able to expand our product line, our specific services that we offer to those specific integrators, helping them win the entire job. So it's been a great growth opportunity for us as well as our customer base.
Appreciate that high-level understanding and a little bit of a walk down memory lane. I personally feel what you and the team have led and tackled over the last few years has been monumental, for lack of a better word.
It's a good word.
I mean, you've probably done more in three years than most companies would be in 10, potentially. I want you to talk about the Snap One acquisition and integration, the ERP, and then the planning for the separation, arguably all at the same time, and what that's done for the company, management's time, and how that sets you up, I believe, in a stronger footing going forward than obviously where a few years ago.
There's a lot there. You nailed it. One of those three things, if I had my way, or I think any distribution business of our size and scale would probably tackle those things on a two-year basis, then move on to the next one, then moves on to the next one. Sometimes timing works with you, sometimes timing is not in your favor. For us, we just happened to, we were two years into a significant ERP change-out planning in the biggest part of the business. The Snap One opportunity came available to us. We all thought long and hard about where we were. Nine months from the day we were projected to close, we were going to flip the switch on the ERP system, which included the ERP, included a WMS, that also included demand planning.
Our plan was to do a big bang, kind of all at once versus drain this thing out over two years and have it be a distraction to the leadership team. We did the Snap deal. We continued on the progress to get to the ERP change-out date. Along those nine months, the spin opportunity came available. Ironically enough, the day we flipped the switch on the ERP system was the actual day we announced the spin. Just the-
You guys didn't know you were going to do the spin because you had to negotiate with Honeywell-
No
on the indemnity, so.
That was four or five months prior, right?
Yeah.
And we were already well into the Snap deal. We were already into the ERP. I mean, these kind of things were already kind of underway, and we just had to try and manage it all in parallel. It just it is what it is. But we got through it, the team embraced it, and we're in a much better spot today now to leverage a modern tech stack. I mentioned in the Q2 call this One ADI initiative, and that's something we're going to talk about over the next couple of years. What that is designed to do is simplify the business while at the same time improving our customer experience. A big part of it is the $80 million+ of run rate cost that we plan to take out between now and the end of 2027.
Three big chunks of that, we've got a real estate footprint that has redundancies after the Snap deal, as well as acquisitions that we did prior. So think about 15 DCs down to about nine, increased cubic square footage, better placement of the DCs based on migration of our customers. Store locations, about 140 some odd locations today, consolidated down to about 115, because we don't need a Snap Partner Store 500 feet away from an ADI store. Right? So we're going to consolidate those, better customer experience.
ERP systems, when we did the deal with Snap, we had 16. Now we're at eight. In exit 2027, early 2028, we'll be down to three. One in the Americas, one in Europe, one for product development. Websites, true e-commerce websites, it's $1.4 billion going through those sites, but it's three of them. adiglobal.com, SnapAV.com, SnapPartnerStore.com, consolidate down to one.
All the expenses that come with that, the customer friction points go away. You've got brand proliferation that's happened over time. I think 22 different brands in our exclusive brands lined up, rationalize that down to 12. All the dollars it takes to actually keep brands going, marketing those brands, it gets consolidated. It's a more efficient marketing business as well. So all these things come together to create a business now that is just more efficient, increased customer service. And now, as we go forward, any other focus areas that we put on the business, we're able to maximize capital, management focus, resource allocation to be able to drive higher returns once we get through this next year and a half.
So that's the best way I can describe it, the sum of what we went through, but more importantly, the benefit and where we're going to be once we get through this in the next year and a half, two years.
Let's take a few of those and double-click into them. Snap One. What was the rationale when you bought it? What did you expect the business to do? What is it doing now, and how do you think about the next one or two years?
Yeah. Great question. Look, here's the reality. I had been looking at Snap since 2015. I first met with them here in the city in 2015, and they were $150 million at that time. We always had our eye on them as a way to get into the residential AV space. Certainly, a big part of their business is exclusive brands, higher margin products. We met with them a few times, and they say every deal dies three times before you actually get it done, and that's exactly what happened here.
But look, when we were in the middle of looking at the actual deal, we had some consultants, we had a lot of analysis that said, by the time we close the deal in mid-2024, we expect to see a recovery in the residential space in the back half of 2023. We felt good about that data.
That, as you know, Dan Stratemeier, did not happen, and it's only continued to get softer since that timeframe. We've had to react. While we still believe in the product category, we believe in the residential AV space, we've got too much exposure there as a business right now. You think about the Snap product line, roughly $800 million, $600 million-ish in the resi AV space, all 3x the margins of our base business. Right now, that's exposure based on a declining residential AV market, which we thought was going to rebound by now. Everybody has seen the data that's out there. If you look at publicly traded residential new construction companies, distribution businesses that are publicly traded, that play in the building supply sectors, all down mid- to high single digits. No real sign of recovery.
Our plan there is we've got to work as fast as we can to make that product line more resilient. As we think about this R&D capability that we picked up with Snap One that produces 400 new products a year, primarily in residential AV, how can we now shift some of that focus and have half of that product line, that new product introductions, be more in the light commercial space across security, Pro AV, Datacom, where we have 100,000 ADI customers? That doesn't happen overnight. Product development cycles are a year and a half. That is the focus right now. Protect our flank in resi AV, strengthen our go- to- market there, but get more new products in the exclusive brand space going in light commercial.
That way, we're much more resilient to any, whether it's residential or commercial, we've got to make that product line more resilient.
Understood. There were disruptions on the cost, and then on the revenue side on the ERP.
Right.
Where are we now? Customers back, market share back. What's your pipeline look like? I guess that sets up some little bit easier comps in the back half of this year, which we can talk about in a second. But where are we mark-to-market today with ERP customer losses coming back?
Right.
Not customer loss, the share of customer.
Share of customers. Yeah.
There you go.
The good is when we flip the switch. We have great data, terrific BI capabilities. We monitor our customers, right? We know what they're buying, how much they're buying, how frequently they're buying. The good news is, over the three and a half quarters post-ERP implementation, the customers roughly stayed with us, right? Some of them just bought less because we weren't as fast as we had been before. Customers would walk into an ADI store, and instead of seeing one person at the counter, they'd see four, and they needed to get in and get out. There's a competitor 1,000 yards across the street, and so that happened. But they continue to come back, buy with us, just buy less.
I think we came out publicly and said we thought there was about a $60 million impact in the back half of last year, which now we're lapping this year. In terms of where I sit today, I am incredibly comfortable, excited about the fact that, look, can you say we've won back 100% of the share? I think that's a bit irresponsible. But everything I'm seeing would tell me that, yes, that is in fact the case. Across all of our commercial security, Pro AV, Datacom categories, we're seeing a daily sales average that is north of where we saw it as we went into the ERP change last year.
I feel really good about our ability to have won the share back, but now do what we do best, and that is continue to take share going forward and drive incremental growth, especially in the security commercial categories where the end market demand is absolutely there.
I believe the old ERP was 40 years old.
It was 40 years old. AS400 green screen. Yes. Thank God I never have to go into another one of our stores and see that again. Yes.
As a part of the One ADI, on a high level, how many ERPs are you still running, and where will it be in two years?
Yeah.
Investors like to know the granularity of where cost savings
Yep
are going to come from. I am going to ask a few questions about that. Then what will it do for your company now? I guess it is in 2028 and beyond. I presume, how we should be thinking about it.
Right.
You are still doing the heavy lifting this year and next year. What will that do for you now that you have-
Yeah
a cutting-edge ERP across all your platforms, I believe, by the end of 2027?
That is right. Let me take the first part. I think I mentioned earlier, when we acquired Snap, we had 16 total ERPs. Fast-forward, as we sit today, there is eight. By the early 2028, with our One ADI initiative, we will be down to three. And that we will stick with. One that is in the Americas, one that is specific to our international business, and one that we need just to kind of manage product development, which is our exclusive brands line. So that is kind of the ERP. Now, we had some folks today that I talked to, they were a little nervous about getting from eight to three.
Oh my God, are we going to see the same thing we saw last year?" What I would tell you there is no, because the way we are doing it is more of a site-by-site, regional kind of rollout here, where you are not going to see those disruptions. We have a great playbook. For example, as we consolidate DCs, as we consolidate stores, they move on to the existing ADI platforms one by one. We have the opportunity to allocate resources to those local teams to be able to do that. I do not see disruption getting from eight to three. That is kind of part one. The capabilities this unlocks for us, as you can imagine, are single ERP. You think about any kind of M&A deals after that. You think about investments in technology.
You think about AI, the ability to leverage data that is all in one source. All those things come together with our three ERP systems. We are not having to duplicate. We are not having to duplicate costs. There is simplicity in the business. We are able to move much faster. This is a significant kind of, I would say, accelerator for us that we get back to the days, we had limitations with the AS400 system, but it was only one system, one set of data. But it was limiting in terms of advanced technology bolt-ons, data, AI, those kind of things. We are making that a big part of our strategic focus going forward.
It was the linchpin to simplifying the business, but also being able to invest in technology going forward without a bunch of middleware complexity, all that centralized in a small group of ERP systems that provides simplicity and leverage.
Great. Let us turn to margins a little bit. Why don't you take us back to the beginning of 2023? I think it makes sense-
Right
to go back then.
It is a good time.
Walk us through the tailwinds and the headwinds to gross margins and bottom-line margins. Basically, just take us from 2023 through 2027. You have obviously announced at the Investor Day, and $30 million, or 80 total, 30 this year. Just help investors understand the moving pieces there, and how they should think about potentially, on a high-level basis, maybe flow through and
Yep
gross margin stuff.
I will just stick to gross margin for now.
Okay.
If we want to talk about operating margin
Yep
we can do that, too. Gross margin in the first half of 2023, by the way, were pretty darn good because in fact, really throughout 2023, if you think about the entire year, largely driven by tariffs. Distributors love tariffs, or price increases in general. Now, it is an art to be able to execute and take advantage of those at a high level, and it is something we did masterfully well in 2023. There was Liberation Day. Every day there were, in some cases, hundreds of different SKUs that were affected with price increases. We have a very mature merchandising team where on day one we were able to raise prices. We did not have any negative effects.
We also have terrific terms with our suppliers where a lot of cases, minimum 15, in most cases, 30 days, they have to give us a heads-up that they are going to actually increase prices to us. While the tariffs affected them right away, we had typically a 30-day period to be able to bring in a lot of cases, a lot of inventory from that supplier, but now at a lower average cost. By the time we raise the prices in the channel, the lower cat lost inventory comes in, which has sometimes five, six months of shelf life. That is a significant margin tailwind that we were able to drive in 2023. 40 basis points for the year, 80 basis points when you think of Q2 and Q3. That was 2023.
Back half of 2023, we were dealing with the ERP change and the revenue, the top-line issues, but from a pure gross margin perspective, a significant tailwind. As a distribution business, to overcome an 80 basis point margin headwind, there are not a lot of levers there unless you have got another round of price increases and those kind of things. We got a little bit of relief from $20 million of tariff refunds that we got in the second quarter. Largely, as I look at 2026, we have two sets of headwinds. One, I already mentioned it, the tariff tailwinds last year are headwinds this year to the tune of 80 basis points, minus the refunds. The other piece is this continuing challenge of our softness in the residential AV space.
That continues to represent a challenge for us because at Investor Day, Dan Stratemeier, we said the arrow pointed down. We thought holding line flat is one thing, but it continues to actually be soft and be down year- over- year. The unfortunate part about that is, as we talked about earlier, that is a $600 million, $700 million category that is mostly exclusive brands, that is 3x the margin as our base business. That is a significant exposure for us in terms of when that particular category is not growing.
You combine the margin headwinds from 2023 or tailwinds from 2023, they are now headwinds in 2026, plus a residential AV exclusive brands category that is pretty significant in size at 3x the margin, not growing. Those two things represent some pretty significant headwinds for us this year. I think to your point, you mentioned going out a bit.
In 2027, at least just from the Q2 $20 million refund , which we'll have to lap, I look at 2027 as an opportunity to continue as we get further through 2027 into 2028, leverage the One ADI initiatives, continue to drive exclusive brands, Pro AV and Datacom, which are margin accretive, and really the ultimate headwind which will exist in 2027, maybe even 2028, we'll see, is just the resi macro. When does that recover? Nobody knows at this point. But in the meantime, we're going to do everything we can to try and at least hold serve on the resi side and really leverage the growth we're seeing on the commercial side.
I guess I forget the exact number of the CAGR you gave on the revenue side. If historically the commercial construction organic number, I think you've done 5%-6% since you've been there.
Yeah.
Something like that, revenue?
The CAGR, yes.
Is that how you're thinking about the next few years? All else equal.
I think we
the bogey will be what
Yeah
Resideo does, obviously.
I think at the investor conference, we gave 4%-6%
4%-6%.
as our range between now and 2030. We do do our best to actually look at the Resideo AV performance right now and say, "This is what we expect between now and 2030." The expectation is that we're not going to see a lot.
Who knows?
Well, we're certainly not going to say it's going to be 5%. It's basically flat at best over the course of the next few years. If someone came in the room right now, Dan Stratemeier, and said, "Hey, listen, I've got some data that says in 2028 it's going to really rebound," I'd say, "Great. I hear you, but that's all I'm going to do is hear you." We're not going to make any adjustments based on that, because I think we all just want to see it.
Yeah.
When we do that, this thing has an opportunity to really be an accelerator for us from a margin perspective. Right now, we're going to assume pretty flat to downish behavior and try and make that product line less exposed, more resilient by producing more products in the light commercial space. That's what's in our control.
Yep. Are you thinking about gross margins for the next two years, flattish is how we should be thinking about it, investors should think about it? I guess over five years, there was obviously a significant improvement over five years.
Yes.
I guess a lot of the resi will take that, eat away at that.
You're right, Dan Stratemeier. I think one of the things we said at Investor Day was, "Don't expect gross margin to be linear.
Linear. Yeah.
As we look at all the initiatives around One ADI, as we look at just the residential macro today, what we think it's going to be in 2027, probably parts of 2028, that the real margin uptick, which I think we said from now through 2028, we expected 40 basis points of improvement, was largely going to be 2028, 2029 and 2030.
Yeah. Yep.
is how we're modeling things.
And you are investing in parts of the business. Why you gave the gross cost out number
Three parts, yes.
and not the net. Why don't you talk about what you're excited about to be investing in, what you think the return on that
Yeah.
that will be.
The three areas that have driven the highest return for us in the past 5+ years, one is our e-com experience. I would put our e-com experience today up against anybody that is out there in the market. AI specific tools, search, nav, personalization capabilities. We continue to launch new features. Some of our smaller integrators can run their entire business, with the exception of ERP capabilities, through the website, and really not even have to interact with a human being. And that is what they have been calling for. Those are the capabilities that we have built. We need to continue to invest there. It is 2% higher gross margin than the base business. Every transaction, it is a stickier customer.
What percentage of the transaction now go through the website?
30%.
It is 30%.
30%. 30% of the business today, God, when we spun from Resideo, I'm sorry, when we spun from Honeywell in 2018, we were barely doing $150 million. Now it's $1.4 billion.
That's impressive.
We want to continue that upswing. It's growing in the high single digits, sometimes double digits. That's just no signs of slowing. You've got to launch new features and continue to listen to your customers.
Pro AV and Datacom are the other two, and we're not talking about a ton of investment. It's more geographical coverage. It's boots on the ground outside, boots on the ground inside, some engineering capabilities. Not product development, but just putting projects together, design work, registrations, those kind of things. The opportunity is there. The smaller integrators in the Pro AV, Datacom sector, I think are underserved. We've been doing a great job there as now we are actually building capabilities for larger projects, especially in Pro AV, but Datacom as well. The end market demand is there. We'd be crazy not to continue to invest there.
But methodically, measured, not recklessly. That's the discipline, that's the approach we're going to take going forward. But outside of that, it's cost takeout, it's drop as much to the bottom line as we can, which our intention long term is to every year, have EBITDA be growing faster than we're growing revenue. Driving fixed cost leverage, and not be in a situation where we're kind of having to cut our way to profitability.
Understood. My last question would be, remind us your free cash flow conversion, and in the near term, what is the highest priority for your free cash flow?
We hover right around 80%, 85%. We've delivered that, I don't know, for the last decade or so. We're not a capital intense business either. The next couple of years will be a little more high, CapEx will be a little higher because of the real estate consolidations, but typically 80%, 85%. We have three priorities in terms of how we're going to actually utilize cash going forward. Number one, which shouldn't be a surprise to anybody, it's de-levering the business, spinning out right around 3x. We want to get down to 2x. That's priority number one. That will remain in place. Priority two is organic investments in growth categories that I mentioned already, the three areas I mentioned. A distant number three is tuck-in acquisitions.
I'd say, look, one of the things is this was a tax respin from Resideo, and so for a year and a half, two years, we're going to be restricted to do anything that alters the capital structure of the business in a significant way. There's thresholds. I look at that actually as a bit of a gift. We can't do any big transformational M&A. Fine.
That One ADI initiative I talked about, double down there in the next year and a half, two years while we're in this bit of a restricted state, operationalize the business. If transformational opportunities come down the road, great. It's a much easier integration than if we were to do that today. In the meantime, a high standard of looking at tuck-in acquisitions, margin accretive, obvious synergies that can be realized really fast, really simple integration based on what we know.
A very high standard before we would think about doing anything like that would take priority over the first two areas that I talked about.
Great. Thanks again for coming. I am going to leave the last minute for you here to have any closing remarks at your first conference as a CEO.
No, I appreciate that.
Thanks again for coming, pal.
I do appreciate the questions. I appreciate just everybody kind of understanding the story, where we have been, the track record that we have had. Some of the things you mentioned, you started off with this, Dan Stratemeier, which I really appreciate, the last two years and just some of the turmoil that we have been through. But just that from an investor perspective, most of that heavy lifting and the turmoil, if not all of it, is behind us now. The One ADI initiative we have got line of sight on. This is a business that knows how to execute, so you can expect us to continue to do that. Expect us to continue to excel in our commercial core categories.
We're kind of back to where we were prior to the go live, and continue to just fight against the residential headwinds, which are here today, and they're going to be here for probably quite some time. But I feel like our plan overall puts us in a position to do as good a job as we can to mitigate those things.
Well, good luck.
Thank you.
I know you'll fight the fight, and thanks for coming.
We'll fight the fight. Appreciate it very much, Dan Stratemeier. Thank you.