All right, good afternoon, everyone. Thanks for joining us. My name is Dave Manthey. I'm Baird's industrial and building products distribution analyst. Thanks for joining us for the 55th Annual Baird Industrial Conference. We have Resideo to speak with us today about the business. And Mike Carlet, Chief Financial Officer, will give us a brief overview, go through some slides, give us a presentation. I've got a number of questions. We will take questions from the audience as well. I think there's some interesting things happening here in terms of the structure of the company, and we'll look forward to hearing about that. So with that, I'll turn it over to Mike.
Thanks, Dave. Appreciate it. Let me just start out. Not everybody knows the Resideo story. I've been at the company about 18 months. I have Chris Lee, our head of IR, sitting here with me. He came about the same time. Resideo is a business that was spun out of Honeywell about eight years ago in 2018. Honeywell took all of their sort of home residential products, which were not a business within Honeywell. It was a bunch of product lines. They packaged them together. They combined that with a distribution business that was mostly on the commercial side, ADI, and put that together as Resideo and spun it off to the shareholders in 2018. As part of that spin-off, they also put an environmental liability indemnification in place with the company.
That resulted in the company being required to pay Honeywell about $140 million a year for a long time, 25 years. That all happened. The company came out of the gates, did OK, had some stumbles as we were putting together the company as it learned to stand alone from Honeywell, but got through COVID, has done a bunch of good things to really fix the operations of the business. Again, this was putting together a bunch of disparate businesses within Honeywell and creating one entity. Making sure there were ERP systems and supply chains, and you had one good manufacturing base. All those things had to be done. Had done some M&A over the last eight years, bought First Alert back about four years ago on the fire and safety side. About 18 months ago, we bought Snap One, which was on the home AV control system.
I actually came from the Snap One side, so I was the CFO of Snap One, and moved over to the Resideo side when that acquisition got completed. Today, we're about a $7.5 billion business on an LTM basis. We have adjusted EBITDA of about 10.5%. And a bunch of brands that you could see there: First Alert, Honeywell Home on the thermostat side, strong business. We really operate as two segments, one segment being the product side, all those residential products, the other being the distribution side. On the product side, our P&S business, products and solutions, it's a manufacturer of building products focused on control and sensing, particularly on residential and particularly on residential infrastructure.
Think about the HVAC system, the fire and safety system, the security system, things that are built into the home that are sort of agnostic to who the resident of the home is. We're not touching entertainment. We're not touching your smart appliances, all that other fun stuff. Really good business, strong margins, generating good mid-single digit growth, excuse me, and a little bit over $2.5 billion of EBITDA on an LTM basis. I do have a little bit of a cold, which is why I'm not shaking hands with anybody. That's why we're not kissing up here. Excuse me if I get a little hoarse. Again, world-class trusted brands. We still have the Honeywell Home brand name on our thermostat line and some of our security products that we use for it. Really good business.
The other side of the business, our ADI business, is a leading global wholesaler of low voltage products, including security and some audio-visual solutions. Think about ADI as really founded in selling security products to the commercial side of the business. While P&S is very residential focused, ADI was historically very commercial focused. With the Snap acquisition, Snap was much more on the residential side. Now we are servicing both commercial and residential out of the ADI side of the business. It is a distribution company that does have a strong exclusive brand presence. About 20% of what we sell, a little bit less, is our exclusive brand products. Those are products that are on private label. You can only buy from ADI. We love those products, but we also are primarily a distributor of third-party products that are out there.
As a specialty distribution company with over $4.5 billion of revenue, we continue to drive operational execution and excellence as our core business strategy. That is probably the background of who we are if you want to dive into Q&A from there.
Sure. Yeah. Maybe.
If there's anything else around that you want to ask Dave, feel free.
Yeah. I want to start with we've been charged with asking every company at the conference two things. First off is impacts from changing government policies. Anything that, in terms of regulation or otherwise, that's changing that is beneficial or otherwise to your company?
Yeah. I think, listen, we all went through the tariff noise. We continue to go through the tariff noise. We have a big part of our manufacturing base is in Mexico for the products we sell into the U.S. Almost everything we manufacture in Mexico is USMCA compliant. When the tariffs initially came out, it was uncertain about how they were going to be treated. That created some disruption. At this point, the vast majority of our products coming out of Mexico are USMCA compliant, which we think is a benefit to us right now. If policy changes in the future, that could become a headwind. Right now, we think it's a benefit to the way that relationships emerge.
We do have some products that come out of China still on the manufacturing side, whether it's third-party product, some of our exclusive brands at ADI, a little bit of our product at P&S. That has been impacted by tariffs, but nothing that's not mitigatable with price and some other activities that we're doing. Obviously, tax reform, the One Big Beautiful Bill, have all generated some positivity to certain aspects of the business. I think, like most companies, we would prefer to have clarity and consistency rather than chaos. There's nothing that's happened that I think has dramatically impacted the business one way or the other up till now.
OK. Second, this can be whether it's on the product side or most people are talking about things internal to the company, but artificial intelligence, any applications that you're currently implementing, and what are the specific results from those?
Yeah. It's funny. We were going through, we were talking about this with somebody earlier. I think we might be one of the only companies in the world that did not use the term AI in our last earnings script. That was sort of conscious. AI is part of what we do. It's baked into what we're doing, but it's a tool within that. If you think about our video surveillance products, AI is incredibly important to that. From security moves from break fix or break and detect to pushing that to who's crossed my property line, AI is a huge component of what's out there. Understanding with our HVAC products, thermostats, what is the usage? Are people present in the home? How do people use that home? What's the optimal temperature on understanding those things?
Those are all things that we're baking into our products as we go forward. We would view them as tools and parts of what's there as those products continue to evolve. There is nothing in the AI world that is transformational to the products. It's incremental and adding value as we go forward. Like most businesses, we're looking internally to how do we use AI to optimize our internal processes as well.
OK. The stock was down on earnings last week. I guess there were a couple of headwinds that you talked about there. Could you talk about what the surprise was relative to what it was apparently street expectations?
Yep. Yeah. I think in the quarter, we still delivered against the street expectations. Our quarterly results were well within our guidance range. What we ended up doing is taking down guidance for Q4 for the rest of the year. Really, two big things happened post our Q2 announcement when we gave Q3 earnings. Two things happened. One, we were implementing an ERP system at our ADI business. We were replacing a 40-year-old system, green screen, AS/400 system that we'd used forever, with obviously a state-of-the-art process and system. We've now been on that system for the last three months, and it's running very well right now. The transition took a bit longer than we thought. In our Q3 guide, when we originally guided, we knew we'd have some headwinds, both from a revenue standpoint as well as a cost standpoint as we went through that transition.
We thought we would get through most of those headwinds within Q3. Those headwinds cost us about $15 million of EBITDA in Q3, which was in our guide. As it took longer than we thought to get through the training, the learning curve of the folks in the stores that have to use that system, some of the technology aspects of it, making sure it's operating optimally, it's bleeding more into Q4 than we thought. While it cost us $15 million in Q3, which was anticipated and in the guide, we now believe it's going to cost us another $15 million in Q4, which was not in our previous guidance. That causes us to take the guide down for that amount and the total impact of $30 million. That's on the ADI side from ERP. Again, it's behind us at this point.
The system's up and running. We're seeing our order book as strong as it's been prior to the ERP implementation. We're seeing our backlog very, very strong as well. On the P&S side of the business, one of our primary categories is in air products. Thermostats is a very, very big component of our business. We're also in filtration and humidification and air quality, AQS. The HVAC business, as many people may have heard, is going through a transition of the refrigerant that's used. We don't use that refrigerant in our products. We're selling products that don't have refrigerant in them. What was happening was the HVAC industry, the distribution, the channel was stocking up on products that had the refrigerant so that they can make sure they can go through that transition effectively. They weren't stocking up on our products.
We did not expect to have any impact from the transition. We're agnostic to which refrigerant's being used to which product. Because we weren't seeing any stock up, we did not expect to be impacted. As we got into the middle of Q3, towards the end of Q3, we started really seeing some decrease in deceleration in our revenues around HVAC. Unexpected, continuing to Q4 now. What we're learning as we talk to our distribution partners, as we're talking to our end users, is because they stocked up on the big components, the Carrier, the Trane, the Lennox, all the big stuff that goes in there, they've got a glut of inventory sitting at the distributor level. Because that glut of inventory is there, they're really scaling back all of their purchases of HVAC equipment.
While our inventory levels did not increase, they're still not buying our product because they have to get through everything that's there, which is causing a step down in it. We do not believe that the underlying macro factors that impact demand of HVAC have fundamentally changed. Housing starts, remodel activity, resale activity there are in our world haven't fundamentally changed. We do think there could be some short-term demand impacts as people are working through this transition. As we sit here today, we don't believe there's any fundamental change in the HVAC market over the mid to long term. We believe this is a temporary dip. Again, the bull case would be that there'll be a bounce off of this, that it's stepped down, they're burning through inventory, it'll bounce back up. We're not planning for that. We're not including that. That's the bull case.
What we're just assuming is, hey, we're running through this headwind right now as the market readjusts to whatever the new normal will be, and we'll recover very quickly. I think most of us believe it'll be like by the end of Q1 that we'll be mostly through whatever disruption this is causing. Again, we didn't expect to be impacted by it because, again, our product's agnostic to it. Those are the two things. That cost us in Q3, we had a 13% decrease year over year in our air products business. We're expecting something similar in Q4. Between those two quarters in Q3 and Q4, it's about a $30 million EBITDA impact on that revenue decrease, which was not in our previous guide. We included that in our guide right now.
Our expectation going into next year is it might bleed a little bit into Q1 as well.
Two questions on that. One on the ADI side, was there lost sales because of the ERP then?
Yeah. The $15 million impact is really broken up into two buckets. One bucket is lost revenue. We closed all the stores for a day, one to two days, depending upon where the store was, to go through the transition, lock it down, make sure we were in good shape. The other piece of lost revenue is, as you're taking someone who's worked on the old system for 40 years and training them on this new system, things take longer. Sometimes they take longer for a week. Sometimes they take longer for a month until that employee, that team member really knows how to manage that system appropriately. While that's going on, you have people that get frustrated. They go elsewhere and shop as we're managing through that. There's been no indication that any of that's been permanent. In fact, almost all those customers have come back.
There's always a few that still want to say, prove it to me, show me that you're through this. Because we sit here today, the vast majority of that has recovered back to where we were. The other half of the cost was on the SG&A side. Everything from expedited freight, again, to get in front of that, consulting fees to address some of the problems, over time in the DCs to manage through the process as we go through it all. The $15 million impact in each quarter is roughly split between margin impacts from lost revenue and SG&A costs from those incremental costs that we're incurring.
Is ADI a branch-based business?
It is. We have a little bit over 100 branches in the U.S. that are ADI branded. We also have 40 branches from the Snap acquisition that are still branded with the Snap One brand.
OK. When you say people went somewhere else, they literally went somewhere.
They literally went somewhere else.
OK. You think those are they continue to be customers. They just needed this product. It was not coming fast enough, so they decided to get it somewhere.
Absolutely right.
OK. On the HVAC, that's not terribly surprising given what we've seen in the industry. Watsco's unit volumes were down double digits. Obviously, the fourth quarter is probably going to be as bad. I don't know what happened. Are the Honeywell thermostats that you're selling, is that a premium product? I would imagine there's the regular old dial product.
We have the entire product suite from a low-end old dial. In fact, we've been in the process right now from a new product standpoint of refreshing the entire T-Stat line. In fact, we just came out with a really cool new product, the Elite Pro. It's what I'm going to put in my house, by the way, which competes with the Nests and the Ecobees at the very high end. It's probably a product that we've been lacking in our product screen that literally we just launched this quarter. We came up with our FocusPRO, which was a redo of the low-end side of the market. We're working on redoing the middle piece of the market. Our thermostat line covers the entire product screen that's out there.
OK. It wasn't this case where the consumer is going good, better, best, going to the good or even below.
We're not seeing that now.
They need a thermostat if they're going to get one. It is just interesting you're attributing it to an inventory situation when I would attribute it just to lack of sale, lack of demand that we're seeing through the other distributors.
It is. I think the question we keep asking is, what are the underlying demand factors that would have caused HVAC to change, but not change our safety business, not change our security business, not change the other business that are also residential? This is very, very isolated within our business to just the HVAC channel. Again, unexpected. If there is an underlying, listen, you're managing through demand, right? There's always going to be some noise as you go through this. There is clearly some demand. We believe it's very, very short term as we go through this, that the underlying factors, the incidence of repair, you can't really defer fixing your furnace or your air conditioner when it breaks. It's generally either new home or break fix.
There is no reason to believe that either one of those core drivers of demand is really changing right now.
Sorry to keep drilling in on this.
No, it's OK. By the way, I love this is we believe, but this is what we believe. We don't know. If there's other information, we're constantly asking to say, what else can we learn around this?
What I'm wondering, because there's this thesis that there's more of a repair versus replace dynamic going on because of the stress at the consumer level. What I'm imagining in my mind, based on my own experience living in Florida, when you replace the air conditioning unit, that would be a reason to change the thermostat as well, as opposed to if I was fixing the air conditioner, obviously, I wouldn't replace the thermostat at that point. Is it possible that that trend is also sort of exacerbating the situation?
That could certainly be. We know that there's a correlation between repair, the replacement of either air conditioning or the furnace side, that you're going to replace your thermostat at that time. Certainly on the furnace side, our installers, our professionals that are our customers will tell you when they replace a furnace, they're replacing the thermostat. They're not hooking a new furnace up to a 20-year-old thermostat that's out there. Air conditioning gets a little bit different as you go through. There's a little bit different correlation, but it's still very correlated together. Yeah, that's certainly a possibility.
OK. All right. Sorry about that.
No, that's fine.
If there's any questions, by the way, please feel free to raise your hand if you want. Otherwise, you can send it to session2@rwbaird.com, and I'll grab those up here. In terms of the guidance that you provided now, you feel that you've appropriately de-risked based on what you know on the ERP side and based on what we just talked about in terms of the demand side of HVAC? You sort of incorporated all that, and that's the result?
We did. And we are very comfortable. Again, we do not know what we do not know. We are now sitting here the middle of November. We gave the guide two weeks ago now. I cannot keep track anymore. A week ago. Just a week ago. We are very comfortable with that. If something is different about HVAC that we do not see, if it all of a sudden falls off the cliff further, we do not know. We feel very comfortable where the guide is. By the way, the rest of the business, as I said, continues to perform. Despite the fact we had a 13% headwind in our air products business, we were up 2% in the products and solutions business in Q3 year over year. Our energy business, our security business, our water business all showed growth during that time.
Without the HVAC piece, I think we were in pretty good shape.
OK. Fair enough. I think one of the most critical issues here that we should talk about is the separation efforts. Maybe you could talk about what you're doing there, the thought process behind it, and where you are in the process today.
Yep. When I joined Resideo about 18 months ago now, it was August of last year, we talked about why are these two companies together? Why did Honeywell, when they spun it off, put them together? What's the strategic rationale? We talked about vertical integration. The fact is, single-digit % of sales of P&S products are sold through ADI. It's not a significant vertical integration play. I don't think either business is overly harmed by being under common ownership. Somebody's got to own them. There's no real strategic reason they belong together. If they don't belong together, why are they together? What's the benefit of separating them? I think you could see here, we get sharper focus.
The operational focus of each business, being able to stand alone, flexibility to operate the business the way they want without having to think about the other side, tailored capital strategies, clarity to the market, letting investors understand which business they want to invest in, all provide benefit that we think makes a lot of sense. We've talked for years about separating the businesses, but that environmental liability with Honeywell prevented it. As long as that liability existed, we were not able to separate the businesses. For a few years, we would call Honeywell and ask if they wanted to settle liability. They declined to do that. This year, they said they were receptive to entering into negotiations. We were able to settle that liability this year, which then simultaneously we said, OK, if we're able to settle that, let's separate these two businesses.
Let each one stand alone, let them operate as standalone businesses and execute accordingly.
In terms of the.
Yes, where we're at in the process?
Yeah.
We announced it at the end of July. We are about three months into the process right now, a little bit more. The first three months has all been about planning. It has been putting together the long-term models for each business, making sure we are comfortable. It has been doing the work to make sure there are no showstoppers in separation. Are there any legal, any tax, any operating things that would cause us to not be able to separate them, that would cause more cost than we want to bear, anything else? We have identified none of that. We are sort of through that initial planning phase. We are now shifting to an operational phase of doing this. That includes things like getting the Form 10 ready for filing with the SEC. It is going through the legal entity separation.
As an example, in the U.S., all of our ADI and P&S employees and assets sit in one legal entity. They operate separately. There's actually separate ERP systems, but it's one legal entity. We've got to figure out how to separate that into two different legal entities and move people and assets and contracts around. We've got to go through the IT planning. While these are different businesses, they operate separately. They have mostly independent operating platforms from an IT standpoint. There's a bunch of shared service stuff. There's a shared network backbone. There's a shared HRIS system. We have to make sure we can separate all those things. If we can't separate them, set them up in a way that allows us to put a transition services agreement in place to operate under a TSA after we separate for a period of time.
That's all the operating planning that we're doing right now. We still feel very comfortable we can get it done and be ready to execute this separation by the second half of next year, as we talked about.
Now with the spin, there's some kind of a, is there like a two-year moratorium that someone couldn't acquire the spun-off business?
There's a two-year moratorium for someone acquiring if you entered into substantive negotiations with that person prior. I think it's a one- or two-year look back. Anybody can buy the company. If you had entered into substantive conversations, i.e., talked about price with anybody, they can't buy it for two years after the fact without making it a taxable transaction.
OK. If this is sensible.
By the way, that's what I've been taught. I'm not the expert on that, but that's what they told me.
That makes sense relative to what I know. My question is, and again, if you can't answer this, don't. I know you won't. Could you tell us if you're doing a dual process here? Why wouldn't you? Why wouldn't you say, all right, we're going to spin this company off and make this a standalone public company, but let's send some books out and see what the interest level is? Why wouldn't you do that? Again, if you can't say anything about it, we'll go on to the next question.
I think can't say much. The board's authorized us to go through a spin process. We're doing that. I think certainly you'll get phone calls from people all the time, whether you're running a process or not, talking about it. We think the right way to drive value in this business is to separate them, go through the spin, and let them operate independently as standalone public companies. We think they're both good public companies. We think they're ready to stand alone. That's what we're focused on getting done.
OK. All right. Let's see. Any questions? Yeah, we got one here, I think. Let's see what we got. OK. How should we think about the capital structures of both businesses post-spin? That's a good question. How will both be positioned to grow through the balance sheet?
Yep.
That's a good question.
Yeah. I think, listen, at a high level, we're working through all the details on this. Our commitment to Tom and Rob, who will be the CEOs of each company standalone. What's really good, those are the folks running each business today inside of us as their presidents. They're both really strong operators doing a great job. We're thrilled that they will be running these businesses once they separate. By the way, everybody asks Chris and myself where we're going. We don't know. In the meantime, we're running both businesses. We're making sure they're both going to be successful. My job is to make sure they're both successful. We're going to set them both up to be successful. We have a certain amount of leverage on the business today. Think about it at a high level.
We're going to take that leverage and prorate it to each business based upon their EBITDA. We'll probably tweak it a little bit based upon whatever specific characteristics going in. We think both businesses will continue to have a focused capital strategy that will be very, very similar to our capital strategy today, maintaining a very strong credit rating, making sure that we generate sufficient cash flow to service our debt, that we have a strong balance sheet that allows us to make sure the business can execute against its strategic priorities. We don't think either one of these businesses will be unfairly burdened post-separation one way or the other. It's going to be ratably as we go through it. Now, again, we need to work through all the details over the next 9-12 months before we get there.
That's our intention as we go through it.
If I read it right, the Resideo side has higher operating margins than the ADI.
Yes.
From a cash flow perspective, are they?
They're relatively similar free cash flow generations, both very strong free cash flow generation businesses. You might argue distribution businesses have a more consistent cash flow. Product gets a little bit more choppy sometimes. They are both very, very strong cash flow generation businesses. Both of them will do a great job in the public markets.
OK. And then I believe when post-spin, you've talked about getting to a double-digit operating margin within three to five years post-spin. Maybe you could talk about where you are today. Actually, here, 7.6. So you got 300 and.
Yep.
240. I'm good with math.
Yeah, yeah.
240 basis points of improvement. How are you going to drive that?
Yeah. I think on both sides. I think you're talking about the ADI side there. I think we think there are significant margin expansion opportunities that continue to exist at both sides. At ADI, that margin expansion comes through a few things. One of them, the continued driving of the synergy and integration of the Snap One business. Part of that synergy is not just the $75 million after three years run rate synergy of real cost there. It's also cost and revenue benefits. It's really taking the exclusive brand products that we got from Snap One, investing in those to make them relevant for the commercial market, and continuing to drive more volume to that side of the business. We are always going to be a distribution company that's primarily selling third-party products.
We think there are opportunities where it makes sense to take our exclusive brand products, which have significantly higher margins, and bring them into the market. The other thing that we are doing is we think our omnichannel business is also a good driver of value. When people buy through omnichannel, we end up with more margin. By the way, they end up with more margin as well. We think of our professionals. It enhances their business and their operations when they buy through an omnichannel standpoint. It makes everything just more efficient. We make a little bit more margin on there. Those are the two big things that really drive it. Obviously, we are always driving operational efficiency in the business as well as we go through it. Similarly, on the P&S Resideo side of the business, we have had 10 quarters of successive year-over-year gross margin expansion.
That race is not yet completed. A lot of good things. We are in the middle innings of that continued strategy as we optimize our footprint, optimize the supply chain, get the right volumes running through our manufacturing footprint, as we launch new products that have maybe some better margins around them that we can get a little bit better margin for. All that will continue to drive enhanced margins at Resideo as well. At the baseline, we think both of these businesses are mid-single-digit growth. Maybe there is a little bit of incremental opportunity around that with opportunity for margin accretion on both over the next three to five years.
In terms of you talked about exclusive brands. I don't know which side you were talking about.
On the Resideo side, they're all of our own brands.
Right.
That's just our brands. On the ADI side, we have a lot of third-party product. The exclusive brands and really, when we bought Snap One, Snap One had a very, very significant exclusive brands, i.e., private label or our own products.
What percentage of ADI is that?
It's about 20%. A little bit less.
20%. OK. You mentioned innovation, new products. Just to close out here, I'm not sure, again, what area you're talking about. You talked about the thermostats. Are there other new products, new innovations you came up with here in the past, say, six months that we should talk about?
Yeah, absolutely. We launched our SC5 connected combination smoke and carbon, which really replaced—we worked with Google. And it replaced their Nest product. Google decided that Nest was going to get out of the fire smoke side of the business. We worked with them to come to market with a product that was a direct replacement. Works with Google as we go through it. That's been a really cool product for us as we launched that. We're doing a bunch of things on the security side. It's an area that, as we think about where we maybe have an opportunity, we haven't done enough on the video side. Security as a business is changing. It used to be sensor. You detect when somebody breaks in. Now we're pushing that out. How does that work? And we're launching some new products around there.
Really, across the catalog, we're doing a lot of things. What I would say to caveat that a little bit, most of the products we're talking about today are enhancements or replacements for our existing catalogs. We're not talking about things going into brand new markets or brand new categories. We have some of those things that we're working on. Those are to come in the future. Right now, it's really about enhancing the existing categories we're in.
Very good. All right, Mike. Thank you. Please join me in thanking Mike for the presentation.
Thank you. All right.